PARTICIPANTS
Damian Hoang
Guest Host, Vice President, Portfolio Manager & Senior Derivatives Strategist
Derek Bastien
Portfolio Manager
Speaker 1: You're listening to On the Money with Dynamic Funds, the podcast series that delivers access, insights, and perspective from some of the industry's most respected active managers and thought leaders. From market commentaries and economic analysis to personal finance, investing and beyond, On the Money covers it all. Because when it comes to your money, we're on it.
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Damian Hoang: Welcome to another edition of On the Money. I'm your host, Damian Hoang, Vice President and Portfolio Manager at Dynamic Funds. I'm joined by Derek Bastien, Portfolio Manager, whom I have worked with since 2014, as we partner on managing close to $4 billion in option-based portfolios. We co-manage the Dynamic Premium Yield Fund and the Dynamic Premium Yield PLUS Fund, among others.
Our discussion today will be an introduction to options as an investment and the benefits they can offer to an investor portfolio. Derek, let's start out with talking about investors who are fortunate enough to be sitting on cash at this point, given the volatility in the market. How do you think option strategy can help them dip their toe in?
Derek Bastien: That's a good question. I think that's one that we often get when we go out and we speak to clients is I have a lot of money sitting in GICs. I'm nervous. There's all these macro risks and overhangs. I'd rather sit my cash, and I can lock in my 3%, 4%, or 5%, depending on the GIC. I think ultimately, at some point, you need to get back into the market. If you miss the up days over the cycle, that really eats into your retirement funds over time.
I think for those clients that are naturally hesitant, that are adverse to volatility, option strategies can be a very good alternative because they're low volatility, they're low beta, they offer lower correlation to traditional equity returns. It helps those clients stay invested over the cycle. I think those kinds of clients for those kind of people that are adverse to risk, an allocation to an option strategy is a very good alternative. You've obviously had a lot of experience with that here at Dynamic and in your prior role at BAML (Bank of America Merrill Lynch).
Damian: Well, I think let's pause a little bit here. Let's pretend that I am not a professional investor. I know a little bit about the market because I occasionally watch CNBC or BNN. When you talk about all those things, low beta, low volatility, really doesn't mean anything to me. I'm perfectly happy sitting on my cash, earning 4% a year right now plus or minus with my GIC. Why would I even bother to look at these option strategy?
Derek: Well, what's inflation been the last year?
Damian: 6%, 7%.
Derek: The 4% is great, versus what you got a year ago, which was nothing. Inflation over the last year, you're now mid-high single digits. The 4% is good that you can lock that in, it's risk-free, but it's barely keeping up with inflation at this point. Is your goal as an investor just to protect what you have, or over time, would you like hopefully to at least grow that and accumulate additional wealth?
Damian: You're saying that in order to beat inflation over time, I have to have some risk asset.
Derek: Yes.
Damian: Option is lower risk way to have exposure to risk asset.
Derek: In general, obviously, options is a broad statement, but I think what we do in our funds, selling puts, the way we manage them in terms of volatility.
Damian: Let me stop you there for a second first. Have we done that? Have we beat inflation? Because if your statement is that in order to beat inflation over time, looking beyond the nominal 4% yield in GIC, that's not beating inflation, have our options strategy beat inflation over the past couple of years?
Derek: Yes, you can look at Dynamic Premium Yield Fund, you can look at Dynamic Premium Yield PLUS Fund. It's not what we're here to talk about today, but Premium Yield has done 7.3%-ish since it launched to the end of February and Premium Yield PLUS is about 9.5%. Well above what inflation has been over the prior 10 years for Premium Yield Fund and the prior almost five years for Premium Yield PLUS.
Damian: Last year, as I recall, Premium Yield and Premium Yield PLUS, although they have done well, one of them is barely down, I think, 0.2%, the other one up about 0.2%, but had I sat on my GIC, I would have earned 4%. How are you saying that these funds are better for me or the option strategy better for me than if I just sit on my GIC?
Derek: If you can time the market perfectly and be in cash last year and right at the bottom switch to equities, then good for you. You're the best investor in the universe as a retail investor. Even the best in the business, if you have an 80% hit rate, you're still wrong 20% of the time. If you go back, and you take out, not just last year-- Last year, yes, we were flat. You could have got your 4% in your GIC. Prior year, 2021, you weren't earning 4% or 5% on GICs, you were earning even lower than that. Something like Premium Yield, Premium Yield PLUS, you're now earning mid-teens in Premium Yield Fund, 21% in Premium Yield PLUS.
This year out of the gates, those funds are up high single digits. They protect an option strategies in general. If they're run in a certain way, can help protect on the downside. When markets are strong, you can participate. You can earn more than inflation in those years and then preserve capital in the years where markets are down.
Damian: Let's talk about how these two funds can earn income, and also, just in general, how you can use option strategy to earn income. That comes with some sort of downside protection because, quite frankly, a lot of investor have no interest at this point diving headfirst into the equity market.
Derek: There's obviously different ways that you can manage option strategies, but we'll speak to what we do, and we'll try to simplify that. What we're looking at doing is finding companies that we think are attractive long-term stories that are reasonably valued, and we write put options. Basically, what that means is we sell a put that's anywhere from 7% to 12% out of the money on a particular name we like. If the market pulls back, we buy those names, we buy them on the dip.
What happens is we get paid a premium to write those options. Those premiums that we collect over the course of the year in an option strategy, that's what accumulates towards your return. It generates the premium that you're using to payout your distribution yield. If there's anything left on top of that, it accretes back to the NAV. What you're left with is basically a strategy that has less downside participation than the market because you have that margin of safety on a put option that you're selling, and then you collect those premiums regardless of what the market's doing.
Damian: Derek, remember, I'm not a professional investor. Talk to me in term of real-life business exposure. What exactly do you do when you say that you write a put and earn income, the kind of stocks you think would be a good idea to do the strategy on, and what exactly is a commitment that an investor make when they write a put, and how do they make the income? Really focus on the real live day-to-day layman description.
Derek: Basically, what we're doing is we're taking a view on a company like United Health, and we're saying if we like the long-term fundamentals of this company, and we think it's an attractive business, we don't want to buy it here. We don't want to buy it right now at the price it's trading at. What we do is we sell a put option that's 7% to 12% out of the money from where the stock is currently trading. In United Health, we sell that 7% to 12% lower, and we collect a premium.
Damian: What does selling the put mean?
Derek: What selling a put option means is you're obligated, or you're committed to buy the stock at your strike price. If the stock is trading at about $340, if I sell a $300 put, that's where I'm obligated to buy the stock if it was to sell off. Because I've sold that put option, I would buy it at $300.
Damian: Does that commitment last forever, last a year? How long is the length of the commitment?
Derek: The way we do it is we do options that are anywhere from four to six weeks in duration. Ultimately, you can sell options a year out if you want, but that's not how we run the strategies. For us, we're looking four to six weeks out. Basically, if we can sell an option 10%, 12% out of the money, the stock has to sell off 10% to 12% over the next month for us to be committed to buying the stock.
Damian: This is like a limit by order.
Derek: Yes. The upside as opposed to you leaving that limit order there and paying commission is your direct investing account is going to pay you to leave that limit order there for the next month.
Damian: What kind of income are we talking about that you can collect by leaving these limit orders?
Derek: For a stock that's creating around $340, we would collect approximately, and this is going to vary over time, $4-ish of premium. When we do this across the portfolio, when you do this across a bunch of names, so not just on a single stock, what that generates you is somewhere in the neighborhood of 12% to 15% on an annualized basis because you keep putting these limit orders out there every single month, and a lot of the times they never get filled, but you keep that $4 regardless of what happens.
Damian: That $4 is for the duration of let's say four weeks.
Derek: Yes.
Damian: Every four weeks, I get another $4. On every single stock I make the commitment or the limit order, I get paid an equivalent of $4 so to speak.
Derek: Yes, you get basically an equivalent over the course of the year of about 12.5%-ish. Names that are more volatile, you're going to get more or less volatile than less[DK1] .
Damian: Wait, Derek, if these are good stocks, and based on the way that we run the strategy, I get paid a dividend by buying these stocks. Why wouldn't I just do that? Why wouldn't I just buy this blue-chip portfolio and get paid in dividends? Why do I have to bother with writing puts? Even the way you describe it as limit orders are going to get-- you paid the income. That sounds good, but the dividend is simpler, and I don't have to worry about it.
Derek: Two reasons. One, if you look at a portfolio of blue-chip stocks and even something like the S&P 500 Dividend Aristocrats Index, you're getting 1.5%, 1.2% dividend yield. You compare that to the 12.5% approximately that you're getting through employing options. The other thing is that if you go, and you buy a long only equity portfolio, you're fully exposed to the market. To start this conversation, we were talking about people that are nervous about getting back into the market. Why would they do that? They're sitting in cash. They're sitting in GICs.
If those people are nervous, going into a 100% equity portfolio to collect a 1.2%-ish dividend yield, probably isn't really up their alley. They're adverse to risk. Whereas in the options, you can sell, you can leave these limit orders out there, 7%, 10%, 12% lower from where the stock is trading. You need to have a draw-down in the market beyond that before you actually start losing capital in these names.
You collect a synthetic dividend that's essentially 10 times higher than what you get from holding a long equity. You get a higher synthetic dividend income in this employment of options, and you get a lower beta on the way down because you're not actually long the stock.
Damian: Well, what do you mean by beta? Again, think of me as a non-professional investor.
Derek: Well, basically your beta is your sensitivity to the market. If you have a beta of 1, if the market goes up 1%, you go up 1%. If it goes down 1%, you go down 1%.
Damian: When you say lower beta on the way down, you're saying that if the market is down a lot, I'm going to be down a lot less with this strategy.
Derek: Yes. Again, this is in general terms, but if you're selling an option that is 12% out of the money, so you've left your limit order out there, 12% lower from where the stock is currently trading. For simplicity's sake, assume that this particular stock moves in lockstep with the market. If it's 12% lower and the market sells off 12%, you don't lose a penny. Nothing. That first 12% drawdown, you actually don't lose anything. If the market, let's say it was down 15%, if you owned the stock or you owned the market, you'd be down 15%. Whereas in your limit order, you'd only be down 3% because you bought at 12% lower, and you only suffered that last 3% of the drawdown.
Damian: You're saying that the initial loss that is someone else's loss before your limit order would be impacted.
Derek: Exactly.
Damian: That initial buffer on the downside is your margin of safety when you write puts the way that you do?
Derek: Exactly. The other thing that you're essentially doing is you're buying the dip. For these investors that are nervous or hesitant about buying the market or a particular stock right now, you're waiting to buy it after a sell-off. You're buying it once it's already down 12%. You're getting a more attractive entry point. If you're wrong, if the stock never goes down, if the market never goes down, over the course of the year, you have that premium, the 12%-ish that essentially your brokerage account is spotting you for putting that limit order out there, that you keep regardless of what the market does. If the market is down, sideways, it's up, you keep that premium that you collect.
Damian: It sounds to me like either should look at the S&P 500 or the Dow or the TSX, and I should find the stock that's going to pay me the most premium for leaving that limit order. Doesn't that sound like the basic strategy of what you're employing?
Derek: I guess if you did it that way where you're looking at the stock or a stock where you're getting the most amount of premium, there's a few things that probably isn't ideal with that. One is you're taking a huge amount of risk in one particular name. You no longer have a diversified portfolio. You're putting all your eggs in one basket. Something idiosyncratic happens, or because the volatility was high, you put it in a regional bank because you're getting paid a huge premium. Then all of a sudden, that regional bank collapses and goes out of business, well, you've lost a bunch of money.
Like anything else in investing, using options, you still want to be diversified, you still want to spread your eggs across multiple baskets so that if the market draws down, if there's something idiosyncratic in one particular area of the market, you're not losing all of your money because you made the wrong bet.
Damian: Tell me, what should my selection criteria be if they want to pick a bunch of stock to apply this put writing strategy or, in the way you describe it, leaving these limit orders on.
Derek: What we look for is, basically, companies that are attractive from a valuation perspective that have good growth characteristics, that are high quality. We're looking for a lot of companies that can compound earnings over time, that are going to grow their business, that have secular tailwinds, strong management teams, and track records. That's one of the first criteria.
Damian: Wait a minute. You're describing basically blue-chip companies.
Derek: That's predominantly what we look at is a lot of large cap blue-chip companies.
Damian: Now, when do I collect the income? Do I only collect the income if the limit orders don't actually kick in, as in, the put actually don't finish in the money?
Derek: You collect the income on day one. Right when you place that limit order, the income would show up in your account the second you place it.
Damian: Do I have to give it back if the limit orders don't go through?
Derek: That premium that you collect on your limit order, you keep regardless of what happens. Regardless of whether the stock goes up or down, if you end up having to buy, don't have to buy the stock, that premium you keep regardless of what the outcome is.
Damian: Let's be realistic and describe a little bit more technically what a put writing strategy actually is. How do you trade it, where do these put option trade, and how do you make sure that you don't over-leverage or in the regular mutual fund don't actually use any leverage at all?
Derek: If you're not wanting to use any leverage or limited leverage, basically, what we do is we cash secure or partially cash secure the options that we're writing. Basically, what that means is that if we wrote a $300 put, we set aside $300 to buy that stock. What that means is that if the stock sells off, we have that cash sitting there to purchase the shares. We're not actually using any leverage in that case. Our asset is actually the cash which we earn interest on, which has been a tailwind with interest rates going up. That's basically what we're using to secure the option is cash.
Damian: You're saying in order to diversify, you should look at a broad portfolio of blue-chip stock with similar characteristics to the extent that they should be industry leaders, should have good business fundamental, trading at reasonable valuation, with good management, et cetera.
Derek: Exactly. Spread across various sectors, various industries. You don't want to ideally be concentrated in one particular space.
Damian: If I actually do this in my account, in the worst-case scenario, one day I wake up, I'm an owner of a blue-chip portfolio at a discount versus where this portfolio were trading on day one.
Derek: Exactly. Right. Market sells off like it did last year or during Covid-19, and you go look at your account, your cash is gone, and it's been replaced with all of these blue-chip companies that you bought 10%, 12%, 15% lower than when you initially placed your limit order.
Damian: Now, what if I'm pretty bearish, and I think the market can go down 25% or 30% from here? Can I protect myself a little bit more than just whatever the margin of safety on these limit orders?
Derek: Yes. What you can do and what we do is all of the premium that you collect from these limit orders that you place out there, you can take a small portion of that, and then you can go out, and you can buy protection on the market. If we want to stick with the idea of limit orders, basically what this would mean is that you've paid a small amount of premium to essentially short the market at a particular point.
Damian: You're losing me again. Remember, I'm a non-professional. Let's talk about it in term of insurance. Are you saying that I can insure my portfolio by somehow paying like a car insurance policy, buying some form of worst-case scenario payoff? Let's say that if I total my car, someone is going to pay me to buy a new car.
Derek: That's another way to look at it is basically you can say, for every dollar or $2 or $3 of premium that comes into the fund or into your brokerage account, you take a very small portion of that, and then you go out, and you buy an insurance policy. Basically, if the market was to sell off more than what you initially have for that 7% to 12% lower limit orders, your insurance policy starts paying out. That would help further reduce losses on the way down if the market was to sell off.
Damian: You're saying every dollar of income I collect with those limit orders or those put, I take, let's say, 20 cents to buy some form of protection for my portfolio. How do I buy that protection exactly using what vehicle?
Damian: What we do is you basically take that premium, and you buy puts on the index. SPY; S&P 500 ETF.
Damian: If the SPY, i.e, the US market, was to go down, let's say, 12%, then I start getting paid beyond the first 12%?
Derek: Exactly, right.
Damian: The first 12% is like a deductible on my car insurance. When I wreck my car, they're not going to pay me the entire amount. I have to pay some deductible first. That deductible is 12%. Then once I pay the 12%, if let's say the S&P down 30, then 30 subtracting my deductible, which is 12%, I get paid 18%.
Derek: Yes, correct. That's what you'd be looking at is about 18%.
Damian: That payout help subsidize my loss in my put writing portfolio.
Derek: Exactly. It's essentially a two-pronged strategy. You have the initial protection or the initial drawdown because your puts or your limit orders that you put out there are about 12% lower. You didn't actually lose anything. Then as you said, when the market then gets worse, if it sells off more, your deductible kicks in, and that small amount of premium that you've been paying then helps offset further losses as the market goes down.
Damian: Last year when the various US markets, whether you look at the S&P 500 or the Nasdaq, down anywhere between 20% to 30%, how would this two-pronged strategy have worked?
Derek: It's hard to speak in generalities, but you can go and you can look at the performance of our funds. Premium Yield Fund was down approximately 20-ish basis points and Premium Yield PLUS was up approximately 20 basis points. You can call it flat that in a year where the S&P was down 18%, the Russell was down mid-20s, the Nasdaq over 30, both of these funds were ballpark flat. For someone who's hesitant to get back into the market that is adverse to volatility, you've got a pretty significant amount of downside protection over the course of a year.
Plus, you can look how the fund is done this year, you can look at how it's done in 2021. If the market is strong, if it recovers, if you end up being wrong, and the market goes up as opposed to down, you can at least participate in that as opposed to be sitting in your cash.
Damian: Let's talk using the funds of the proxy for the strategy for a moment. I get paid, what, 6.5% or so in Premium Yield Fund and 9% or so in Premium Yield PLUS. Those are the coupons that I literally would clip every year. Right?
Derek: Yes. That's actually only a part of the coupon that you clip.
Damian: I'm not greedy. Let's say 6% and 9% are the coupons that I clip every year. They're paid on a monthly basis. These are fixed. These are not, if you don't feel like it, you can reduce my yield from six to four or from nine to five.
Derek: Yes. The way that we manage them is they're fixed distribution yields, and then your point on them not reducing, they're not dependent on interest rates. If we go back to the GIC example, right now you can earn, if you look last night, GIC is anywhere from 3.5%, 5% depending on the bank. You can earn that right now, but can you earn that next year if rates go down, can you earn it the year afterwards? You can go back, and you can look at the historical performance. These distribution yields, these coupons that are paying out, they're not dependent on rates. You don't need interest rates to be high to continue to clip those coupons.
Damian: They are fixed, the amount is fixed and pay out every month.
Derek: Yes.
Damian: If I'm lucky enough to buy a Premium Yield today, and if the NAV was to appreciate, then my yield would shrink a little bit.
Derek: Your yield would shrink a little bit, but the amount that you'd receive per month would be the same.
Damian: I have a little bit of capital gains on the NAV portion.
Derek: Exactly, yes.
Damian: To be honest with you, this sound pretty good for someone who's sitting on cash and really hesitant about the fact that is this the right time to get more exposure to stocks. Give me the worst-case scenario. What can go wrong if I were to use these put writing strategy or, as you describe, that limit buy orders in my portfolio?
Derek: You can go back to basically Covid-19. Not too long ago, that is the worst-case scenario for these strategies. The market is down an extremely large amount. In that case, it was 35% in a very short period of time, which in that case it was 22 trading days. You can go back to 2020, and as opposed to theorize on how these things are going to behave, that is your worst-case scenario.
You have a rapid selloff in a very short period of time. In those instances, Premium Yield Fund was down about half of the market from peak to trough. Premium Yield PLUS was down about 60% of the market in that period.
Damian: In the absolute worst-case scenario that I would describe as multi-generational, I'm losing only half of what the market loss was in one fund and 60% in the other fund.
Derek: Yes.
Damian: To take that risk in exchange for one fund, I'm getting paid around 6% of coupon a year. The other fund I'm getting paid about 9% of coupon a year, and I potentially could have some capital appreciation on top of that.
Derek: Correct.
Damian: If the market was to sell off this vanilla style, like in 2022, when the market down 20%, potentially this strategy can even be flat for me.
Derek: Yes. That's what happened last year, and obviously, we would love to repeat that if that happened again.
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Damian: Well, that is very helpful, Derek. Thank you very much for playing along with me.
Derek: Yes, no problem.
Damian: Hopefully this will have illustrate a pretty difficult concept of what put writing on blue-chip stock would look like, not only for us managing the funds, but for regular investors as well. Thanks to all our listeners. Again, this is another edition of On the Money. Thanks for joining us.
Derek: Thanks, everyone.
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