Howard Chan

And so I had this moment where, what am I going to do next? And I think a lot of engineers, when they're at engineering school, they don't think about finance because it's not as rigorous as, say, building a bridge, right? You need to know how many cars you can go across the bridge. But I was wrong. I think it's because the system is so complex that you can't capture everything. And so I kind of fell into it. And it's been extremely fascinating, constant changes, things to discover and learn. And yeah, it's been a great career.

It was kind of when I realized that, a lot of the, obviously at PIMCO and Goldman, you work with a lot of really large institutional clients. And you realize there's a lot, actually a lot of best practices that are not really available or accessible to all investors. And so I actually went back and I talked to a lot of folks who also left PIMCO, but who I worked with the ETF business and I said, hey, there might be opportunity to make things accessible and available. Are you interested? And, a lot of people were actually very interested. So we got 80% of the folks at PIMCO are all folks that I worked with.

And we kind of brought the band back together using a music analogy. And so that's really what we're focused on. I want to kind of deep dive into, two aspects. So, the tax efficiency is actually very important to us because there are actually really a lot of really great institutional strategies that are incredibly tax inefficient. They trade a lot, but that's okay because the people who are using it are non-taxable entities, pension funds, endowments. So they don't really care about taxes. But as soon as you move down to taxable entities, those strategies don't work as well because you have this layer of tax. So our idea was, obviously maybe a lot of your audience, are familiar

With tax loss harvesting. That always philosophically didn't quite make sense to me because you have to have loss first, right? So what we wanted to do is build a strategy that thinks about tax on the gains. And so that's kind of built into each one of our strategies. And I can go into detail when we talk about the various things that we have. And the second part is institutional grade. So your audience probably are aware that a couple of years, 2022, I think, there was a change in ETF rules that allowed derivatives. And what that actually opens up is accessible to the different kind of risk premia that all investors were not able to access unless you were the largest investors, right?

And primarily using derivatives, there's, you have to set up ISDAs, you have documentation, collateral management. Those really were not available to all investors. So what we want to do is just to make that easy. And there's risk premia that, for instance, volatility risk premium that are much easier to gain access to. You can get it in other asset classes like mortgages or, whatnot, but, or assets that have optionality in it. But now you can have a direct access. And these are actually some risk premia that even at my former employers that these are the consistent risk premia that they tap into to outperform their benchmark. So we want to kind of build in these strategies now so that it's available to, to all investors.

There are financials, utilities, and energies, right? And you're underweight tech to get that dividend yield. And if you think about that, you're actually overweighting older parts of the economy, right? It used to be energy is the largest part of the Dow. Uh, financial also was a big component. Those are much smaller now. Um, and then you're underweight the growth part of the economy, right? So we kind of started these single names as a means for people to make that trade off a little bit easier. So if they back buy a basket of those, uh, uh, names, they can actually generate income on a growthy part of the, the, the, the economy, they could still hold the other dividend stocks in the other sectors, but now it's more balanced to what an S&P would probably

Look like. And the other, um, problem that we were trying to solve was actually, these cover call strategies are not like new, right? They they've been used since the eighties for really large, um, private wealth advisors to generate some additional income in folks' portfolio. And, and the, the, the flow would usually be, maybe it's a client driven, Hey advisor, can you look through my portfolio, write some cover calls? Um, and then the advisor would go through, 30, maybe 40 lines items. See what makes sense. They might not know how to trade options. If you're really at a really big advisory firm, maybe, they, you might have a dedicated execution desk so you can execute options.

But if you're a smaller advisors, those are not necessarily even available. So the idea was for these particular names that you can now, even if you're a smaller advisors or self-directed, uh, uh, investors, uh, who are focused on, on income, you can access these strategies immediately. But more importantly, I think most people don't talk about is when you want to exit the strategy, you have to unwind these trades, right? You have to buy your cover call back and all, so now instead of making those kind of unwinding, you can just sell a share of the ETF. So that was the problem we were trying to solve with those funds. And generally those funds are intended to, and we've seen the investor set is generally

People who are close to retirement, who are retired, who want to supplement some of the income. Um, and, and we try to keep the distribution as stable as possible so they can kind of predict what portion of self supplement of income they want to have, uh, in their portfolios.

So you are trading of some potential upside to getting that income. And, um, and that is actually, this is why the original six is very more suitable for folks who are in retirement where they, they're, they don't, the price appreciation potential is not as important as steadiness of income. Um, if I will say a cover call is not a great in an environment where you have sudden sharp increases in price appreciation, uh, because you're capping up, uh, uh, uh, uh, the stocks appreciation, right? So the, the big question always is like, would you have wanted to write a cover call on NVIDIA this year?

Right. It almost would be better for you to ride the price appreciation and sell some shares to generate the amount of income. Right. So I'm, I'm generally pretty, uh, forward about, the cover call strategy is very, good for a specific set of investors that want to have the income. They don't, we think about total return as having three components, right? There's the price return, there's the income return, and there's an FX return. We're generally buying us assets. So that that's zero. So it's really price versus income. And this set of investors really focused on the income that's being generated and less so on the, on the price return. So, yeah.

Was at almost four years low. So when you're writing a cover call, essentially what you're doing is harvesting this volatility premium, right? And, and inherently it's low because in an index, there's diversification in that index. So the volatility, the pricing of volatility would be lower, but on single names, the volatility is actually quite high. So what you can do in some ways is to buy a basket of single names. You get, you get the risk premium first, and then you get the diversification later with the, the, the different combinations of single names. So that that's been kind of, uh, uh, written about in sort of this divergence of single vol versus index vol, uh, that's in the market.

And the way we describe technology is not just software companies or semiconductor companies is any companies that have used technology to essentially leap forward in their vertical. So that includes also, Netflix, which, changed the way that we deliver media. Right. Um, and so we went back, uh, there's been a lot written this year about, how the market is driven by seven names and what's happening with the rest of 493. Uh, we actually did research going back 20 years and see actually if, if this cohort of, of largest, uh, names actually behave differently. And what we've seen is that, um, year over year, even the last five, six years, the, these names have outperformed the overall benchmark.

So if you just use a proxy, like the top 15 names on Nasdaq versus, uh, the Nasdaq 100, which is the broad benchmark year over year, it's actually outperformed 400 basis points about, and that's really unusual because if you think about it, the larger the company is, the growth trajectory should be slower, right? Because the larger part of the market, that, and it just doesn't quite fit technology companies. Um, and, and so what we wanted to do is, and, and by the way, the, the portfolio is generally a name, a basket of 15 to 20 names. So it's not just, the, the largest names, uh, in the basket. Um, and so, so one of the things that we wanted to focus on was the sector is

Attractive, but we do accept that if you, if you accept that this is a, a strategic exposure that you want to have your, have your portfolio, then what is the behavior of this basket? And in technology, we know there tends to be exuberance and then correction, right? That, that is a behavior of the sector. Like the, the most recent one I would say is during COVID. Everybody thought we would never, ever go out of our homes. So, there was a huge price action. And then as soon as COVID went away a little bit, there was a correction, right? So if you accept that this is a strategic exposure and this is the behavior. Then the question is, how do you take advantage when it's during the exuberance phase?

And how do you minimize the correction? That's our premise. We don't, we want to, we don't want to guess whether it's rich or we know it's going to happen. So when it happens, how do you deal with that? Because I think that one of the things that a lot of asset managers really talk about is their view on something, but they never talk about, but what if they're wrong? What hedges do they put in your portfolio? Right? They never, they never mentioned that. So we accept that, Hey, our view is long-term, this is going to be great, but we know there's short-term volatility. So how, what sort of hedges do we put in our portfolio to mitigate when we're wrong? Um, and so, uh, and then, and then the last, uh, the, the, again, we, we try to

Solve for problems for the strategy. So the three things that we were trying to solve for is income on technology sector. That's we've discussed that to how do we deal with this boom and bust cycle in technology? And the third one is actually weaknesses of the cover call strategy. So I, you, you just, you brought up great point, right? Do you, do you, are you trading off some off upside, right? Would you want to write a cover call on NVIDIA? How do you deal with that? So we built the strategy to, to address those three things.

So for instance, I'm using the top 15 names on Nasdaq as an example, uh, Pepsi, uh, uh, Comcast and Linda, which is a German gas company is actually, uh, sorry, Costco is like a huge component of the cubes. Um, and actually if you just remove those because they don't have that growth behavior, it already improves actually the performance of the basket. And then additionally, if you look at other exchanges, for example, Oracle is listed on the New York Stock Exchange. There's other names like ASML. That's not a U S you can buy the, we can buy those. We don't have it in a portfolio right now, hedge out the Euro risk. Then, then you have a more complete picture of what that basket would look like.

So that, that is the first step in, in terms of looking at what is the, the, the core 15 to 20. And, and another thing is that, part of why we're not quite concerned about this mag seven raise up is that there's other names that have underperformed in the basket that we, if there's a mean reverting component to it, we think the other, potential 18 names or whatnot can actually also be performance drivers in the basket.

So what we want to do is obviously, uh, get at the beginning of that cycle, right? So we, uh, on our momentum signal, what we do is there are some shorter term, um, uh, uh, signals. So when we start seeing those kinds of behaviors, we start overweighting by about two and a half percent. And when they're in the middle of that cycle, we'll overweight another two and a half percent. So, so the overweight is actually fairly modest. The maximum is about 5%, but we want to capture some of the overweighting at the beginning of the cycle. And if the momentum tend to be true, then we, we overweight it more, uh, on, um, uh, in the basket.

Now. Yes.

Not on a daily basis. We think daily, there's too much noise in there. Signal to noise, noise ratio is very, very high. And then, and then we have a longer term, um, that says, okay, if the average momentum cycle is 10 months, we can maybe cut that in half and see, get the second wind on those particular names. Um, now this actually brings up to the, to the third part, which is what if a name doesn't have momentum, what happens? Right. Uh, and then in fact, I would argue when a name doesn't have momentum, upward price momentum is actually perfect time for cover calls. So remember in, in environment that I mentioned, cover calls great when it's trading sideways or it's going down. Right. So that when there is no momentum signals, uh, switches on.

So we start writing, uh, cover calls on, on those names that have negative price momentum.

So that's, that's how we think about, and, and, and, and, and maybe I should tell you a little bit of the origin story about this. So, we, we launched the six, uh, cover call ETFs because we wanted them to be tools. People can pick which names they want. And the most common questions we get was like, we don't want to make a decision. We want you, you're the manager. We want you to make a decision. So we could have kind of just did a basket of the six ETFs, but we actually went down back to the drawing board and say, if what is a strategy we want in our portfolio, right? We know the weaknesses of cover call strategies. We want the upside, but we also want the income.

So that's how we came to this dynamic waiting to again, asymmetrically get the upside and then cushion the downside, um, for the strategy.

So this would be used as a, as a compliment. Um, the, the other thing in terms of asset allocation, we thought about is actually the switching costs. So, in the market right now, there's a lot of discussion about, Oh, people are rotating into small cap. I think that story is kind of faded away, but if you're an asset allocator, there's, there's an issue with that statement, which is a unit of risk of large cap is not a unit of risk of small cap. Small cap is much more volatile. So in the asset allocation, you, that's always a smaller part of your portfolio, right? So you can't, you can't just allocate yourself out of large cap. So that's why we decided the downside mitigation is actually more important because you have

This core holding, you have to hold for your risk exposure. And, and, and maybe just, just why do we think about using income as downside mitigation instead of buying like protection, right? I personally have never really seen a tail risk hedging strategy that works. And the reason is because when you buy tail risk, you have to, it's like insurance you want to buy. It's hard to gauge the size of the down, how much premium you want to pay to ensure your downside and how much, how do you size the downside cap that, that you bottom that you want to, you want to cap down. Right. And if you don't buy the, sell this premium and you want to buy a put when the market sells

Off, the put is already very expensive. Right. So, so, and then you're using capital to buy them. So I'm, so our thinking is instead of spending capital, you generate capital to mitigate the downside. And so, so going back to, to the asset allocation question is that also we know many people have held a technology names for a long time, right? They've probably written before COVID. So if you were to really, you can tactically modify on the edges, but if you were to really sell out it, you're going to get a huge capital gains tax. Whether it's long-term or short-term, the tax bill is going to be there. So if you want, you, you, you want to minimize that tax efficiency also, right?

That's part of what we think about is the taxes. You hold this exposure, you generate income. So you don't have to sell out of that exposure and have a tax, tax, tax bill essentially when you reallocate and you hold it. And that income might give you some ordinary income or some whatever, but that's excess capital you wouldn't have ever otherwise have. So that, that was our thinking in terms of this design and asset allocation perspective, where it fits into the portfolio.