On the Money with Dynamic Funds

PARTICIPANTS

Mark Brisley
Managing Director & Head of Dynamic Funds

Damian Hoang
Vice President & Senior Portfolio Manager

Derek Bastien
Portfolio Manager

Mark Brisley: Welcome to On the Money. I'm your host, Mark Brisley. Our objective in today's episode is to help our listeners better understand something that is increasingly becoming a mainstream part of the investing universe, and likely something you are now hearing almost daily about in the market media and news. We are referring to the proliferation and popularity of options-based ETFs, or exchange-traded funds. Their popularity continues to grow this year as investors seek to diversify beyond traditional stocks and bonds when seeking income.

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.

Then demographics. Our largest cohort of savers, the baby boomers, and even the firstborn generation Xers, are entering their more conservative savings life cycle. They are now seeking to generate sufficient returns in income while also seeking to minimize risk of serious losses that they can't recoup in their remaining savings years and real concern around longevity or put differently, outliving their capital.

The compelling value proposition that options strategies can deliver has quickly begun to resonate with a vast array of investors looking to enhance their yields without assuming risk beyond their tolerance. The desired outcomes may be multifaceted, ranging from everything to playing more defense to looking for slightly more exposure on the offense side, perhaps more income, higher yields, and definitely more tax efficiency.

As with any investment strategy that grows quickly in popularity, it's important to understand that approaches to option strategies are often very different, and equally important to understand how these strategies differ and how they can deliver vastly different outcomes. I'm pleased to be joined by our guests today, Damian Hoang and Derek Bastien, portfolio managers here at Dynamic Funds that manage over $12 billion in derivative strategies for investors.

Gentlemen, as this podcast is in the public domain, we probably should start with helping our audience have a preliminary foundation and how such strategies work. Derek, let's start with the basics. Can you explain in simple terms what selling a covered call and selling a cash-secured put are?

Derek Bastien: I think it's important in the context of when we talk about cash-secured puts and covered calls that we do that in the context of not using leverage. Basically what that means is when you sell a covered call, you own the shares and if you sell a cash-secured put, you have cash that's sitting there to buy the stock if it pulls back. To start with calls, essentially what we're doing is you own the shares, you sell a call at a particular strike price, which is typically higher than where the stock is.

Essentially what that is doing is placing a limit order to sell the stock higher, and then you collect income in the meantime. For a put, basically what you're saying is you have cash sitting there, and if the stock pulls back, you're putting a limit order lower to buy a stock you like after a pullback. In both instances, you're getting compensated in income or an option premium for doing so. In a covered call strategy, you're placing a limit order to sell the stock higher, and in a cash-secured put strategy, you're placing a limit order to buy the stock lower.

Mark Brisley: If we look at investors who are seeking income, what income yields are available from these strategies? Then the risk and the yield trade-off.

Derek Bastien: There's a wide range of different types of yields available depending on the product. If we're talking products that don't use leverage, typically you're going to get anywhere from mid-single digit to low double-digit, depending on the flavor of option fund that you're using. As you mentioned, there's a risk-reward trade-off to that depending on the yield you're getting.

With covered call funds, in order to sell a call on a name, you basically need to own the shares. What that means from a risk-reward perspective is that if the stock sells off or if the market sells off, you end up participating on the way down because you own the shares and you've only collected a small amount of income for owning the shares. In a cash-secured put strategy, as opposed to owning the shares, you are sitting on cash and you've written an out-of-the-money put.

Typically in a cash-secured put strategy, that initial margin of safety is protected on the way down. You don't lose as much on the way down because your puts don't start losing money until after the market has already sold back off a certain percentage. You can get better risk-adjusted returns on the way down, but typically if you were to sell a similar moneyness or an option that is just as far out of the money on a put versus a call, you're going to receive a higher yield on the puts just because of supply demand and the way the option market works there.

Mark Brisley: Now that we have a better understanding of the strategies, Derek, which do you prefer?

Derek Bastien: From our perspective, when you look at why people typically use these option strategies, it's to enhance the yield of their portfolio. Typically when you're looking for enhanced yield, you also want lower downside participation when the market sells off. When you look at what puts offer, it checks the boxes there and it does so much better than what calls do, and for a few different reasons.

One, when you sell a put, you have a margin of safety, basically meaning that if the market sells off, you have less participation on the way down and you protect more of your capital, more of your money on the way down. The second thing is that within the market, there are a lot more funds that focus on selling calls. Basic supply demand. If you go back to Economics 101, is if more people are selling something, it's going to drive the price lower. You typically are compensated less for selling calls than you are in selling puts.

You're receiving a higher yield on the put side versus calls. Then the other big thing is that when you're selling calls when we're in a strong market, you're leaving money on the table because basically when you sell a call, you're committing to sell that stock as it starts to work, as it starts to go up. You basically end up selling a lot of your winners, whereas when you're selling puts, you're waiting to buy the dip. Then after that dip, you get to buy companies you like and then fully participate on the way up once you've purchased that company.

Mark Brisley: You talked about why put writing has a superior risk-reward value proposition. Could you simplify that just maybe down to one takeaway for our audience? What would it be that makes it superior?

Derek Bastien: The reason the risk-reward is superior is that because you're backing a put with cash when the market sells off, you participate less on the way down. Then because of the supply-demand dynamics that I mentioned earlier, you're being compensated a higher income for selling those puts. You get a higher yield and you participate less on the way down. From the perspective of someone that's looking to enhance the yield of their portfolio, puts do a better job of that while also reducing the risk on the way down if the market sells off.

Mark Brisley: Damian, for those now that are interested, can you describe ultimately what a covered call ETF is?

Damian Hoang: Derek already described what a single covered call looks like. You own the stock, you write a call option, and it's called cover because you own the stock, and that effectively cover the liability of the call that you sold. If you do this on one or two or three stocks in your portfolio, then you view it as an ad hoc basis. If you have 30 or 40 stocks and you do this systematically on each of those stocks, then you have a full portfolio that is overwritten, as in that portfolio all have covered calls sold back by the stock.

When you have that and you have it in a publicly traded domain or vehicle, then that becomes an ETF or a mutual fund. A covered call could be either or. Sometimes in Canada and the US, you would see different flavors of the same strategy managed by the same sponsor. They would have a covered call ETF and then the identical strategy that in the mutual fund or in the ETF variety, but offer basically the same performance and same risk-return characteristic over time.

Mark Brisley: One thing that's quite evident in looking at the universe of covered call ETFs that have come out, a lot of them pay very high distribution income. How does an investor judge how much of that payout is actually sustainable over time?

Damian Hoang: The simplest way is by looking at the NAV of that ETF. If the NAV of that ETF keep going down while the market is flat or up, that's a pretty good sign that the ETF is paying more than it can afford to. The other way to look at it also is by looking at the disclosure that the sponsor make. Some sponsors are more transparent than the other. For example, the gross internal yield, i.e. how much income the sponsor or the portfolio manager collects using the covered call strategy, all that income add up to the gross internal yield.

When you take the gross internal yield, you subtract some fees in the fund, whether it's a management fee, whether it's other miscellaneous fee. What you're left with is an income that you can pay out.

The gross internal yield is a very good proxy of how much, as a ceiling, a particular ETF can pay out over time without grinding the NAV down. Now some ETF sponsors do not disclose their gross internal yield, and some do. I would recommend do a little bit of homework, find out which one has a better disclosure. Usually, better disclosure means more transparency, and quite frankly, more transparency in these vehicles are more investor-friendly.

Mark Brisley: You mentioned something called NAV, which stands for Net Asset Value. Can you describe that in a little more detail?

Damian Hoang: The simplest way to think about it is price of the ETF. If you look at where the ETF is trading, most likely it's very close to where the NAV is. That's all you need to understand. If the price keeps going down and the market is flat or up, chances are they're grinding the NAV or they're grinding the price of the ETF, and therefore most of what they're paying out in distribution isn't earned, is what I meant.

Mark Brisley: In addition to the income payout that you just talked about, how do we judge the performance of a covered call ETF?

Damian Hoang: By definition, as you know, in order to run a covered call ETF, you need to own the stock, and then you sell the call. When you own the stock, you should really have very high correlation with whatever index that ETF is supposed to track. If that index is doing well, and your covered call ETF that tracks that index isn't doing well, then clearly the performance isn't there.

Let's say that if you have a covered call bank ETF, and if you look at a simple bank ETF, and you see that simple bank ETF is outperforming your covered call bank ETF by a lot, then the manager of the covered call bank ETF should have some explaining to do. Because it's one thing to enhance the income, it's another thing to enhance the income but give up all the upside. Similarly, on the downside, it should really track the index. If your regular bank ETF is down 10%, and your covered call bank ETF is also down 9-10%, then from that perspective, you don't have the best risk reduction vehicle here.

Now risk, what does that mean? Risk means that when one is down 10 because these covered call ETFs are supposed to somewhat reduce the risk, you should be down less. The question is down how much less? Down 1 or 2% less is barely risk reduction. If your vanilla simple bank ETF is down 10, and somehow your covered call bank ETF is only down 6 or 7, that's a good job.

The other perspective also is from the income. A lot of people buy these products for income. If you have a covered call ETF that pay low single-digit income, then there's not a lot of income enhancement there. You want to minimum have a fund or an ETF that can pay 5, 6, 7%, or better if income enhancement is your goal when you invest in these covered call ETF. What you want is a fund that pays sufficiently high income as in enhanced income. You also want a fund that doesn't give away all the upside.

If you're supposed to track bank or tech, then that ETF have to have reasonable participation on the upside. Because these products are supposed to reduce the risk somewhat to the investor, on the downside, you do not want to capture all the downside that specific vertical or industry, or sector has suffered. If bank is down 10, you want your covered call ETF to be down 6, 7. If tech is down 20, you want your covered call ETF tech to be down 12, 11%.

Mark Brisley: We've talked a lot about the proliferation of popularity of covered call funds, and there's been a lot that have come out to the market. The question for you is this a new phenomenon? Because we did discuss the reasons why they're popular right now. Have we seen this trend before?

Damian Hoang: The reality is we've seen this movie before in the early 2000 and leading into the financial crisis in the US and in Canada. There were a lot of covered call funds and ETF and closed-end funds. They didn't do very well. That's why if you go to look for any of them, you just don't see them anymore. Good luck finding a covered call fund with more than 12, 13-year track record, because they just don't exist anymore.

They either get folded into other funds and change the name and change the strategy, or they just stop operating altogether. Therefore, at this point, what you see is really covered call version 2.0. Because I was around when version 1.0 was there, I can tell you there's no difference between version 2.0 and 1.0. Oh, it is that memory faded and people just forgot how badly they did the first time around.

Mark Brisley: I want to shift our focus now to cash-secured put writing strategy. Derek, can you describe what a cash-secured put writing ETF is?

Derek Bastien: I obviously can't speak to all option ETFs and every product that's out there. If you look at a cash-secured put ETF, you can obviously have sector-specific ones that are on the market. How we manage our funds and what we focus on is really a diverse portfolio of blue-chip mega-cap names that a lot of people are already familiar with. Things like the Microsofts, the Amazons, the Eli Lillys, the Walmarts of the world.

Basically what we're doing is we're selling puts on these stocks 7 to 12% out of the money. We sit there, we wait to buy the dip, we get compensated that option premium in the meantime. Then if the stock does pull back, we get to buy a blue chip company we like at a discount. Predominantly, that's what we focus on is puts. For us, when we do take delivery of some of those stocks after a pullback, that is how we'll naturally build up exposure to some of our long equities is our highest conviction ideas that we like after they have sold off.

Then for us, within our funds and within other put funds, you can also have some use of covered calls. For us, we do selectively use them. For us, it's not systematically selling calls on all the positions that we own. We're basically looking to lock in a price that we would naturally want to trim our stocks at anyways. That's where we will look to selectively sell calls as after a stock has rallied and we would naturally look to be a seller anyways. Set our limit order higher, lock in a sell price, and then receive a bit of additional income in the meantime.

Mark Brisley: Let's zone in on the options ETF strategy that you manage, which has a ticker symbol DXQ. It's an enhanced yield-covered options strategy. Derek, can you walk us through its value proposition?

Derek Bastien: The value proposition of DXQ, we can really boil down to one sentence. When the market sells off, less participation, and then robust participation when the market is doing well. Basically how we achieve this in DXQ is a large portion of the portfolio is invested in cash-secured puts, meaning that we're sitting on cash waiting to buy companies we like after a market pullback.

Then once the market pulls back, we're taking delivery of as I mentioned, a lot of these blue chip companies. We're able to basically buy the dips, sit on companies we like, and then through using put options and very selectively calls to try to lock in some of our sell prices, generate a very historically attractive distribution yield that has been six and a half percent currently.

Mark Brisley: As this is a performance-based business and world we live in, Derek, how has it done since you launched it just over two years ago?

Derek Bastien: The fund's done extremely well from our perspective. When we initially launched DXQ on paper, we had a feeling that it was going to be a good fund, just given some of the other mandates that we manage and the characteristics. Basically, since the fund's launched, you're getting approximately 20% returns per year. It's keeping pace or almost keeping pace with the market.

We've been able to achieve that with a fraction of the risk. Right now without getting too technical going into different, risk metrics and characteristics basically anytime the market has pulled back, DXQ has been down a fraction of the market while since inception, basically allowing you to participate in the large majority of the upside.

Mark Brisley: Damian, Derek mentioned a six-and-a-half percent yield, and I wanted to get your sense of where yields are at within the strategy now and what influences change in yield within those strategies. We understand that you're actively managing the fund and the yields themselves.

Damian Hoang: When we launched the ETF more than two years ago, the price of the ETF was $20. The distribution yield over the course of the year was fixed at 7%. As you know, the ETF has done very well, and now the price for the ETF is well over $25. Because of that, because we fixed the yield, therefore the current yield is just a little bit less than 6%. The reality is we collect a lot more than that in the ETF. Now the gross internal yield in DXQ is between 9 to 10% consistently.

When we collect 9 to 10%, subtract a little bit of fee, we still have about 8 plus percent in terms of how much we can pay out on a sustainable basis. The math for us becomes we can pay out 8% plus sustainably over time, and right now because the ETF price has gone up so much, the yield is diluted down to below 6%. There's a 2% gap there that we are having discussion with respect to what is a true sustainable yield that we should have DXQ at. Stay tuned for that, because I really think that given the fact that we can pay out 8% plus sustainably and we only pay out below 6% right now, there's a big gap. I don't like that gap.

Mark Brisley: I also wanted to ask, there's just so many covered call funds that have come out and ETFs. There are not as many, actually quite few, put writing funds in ETFs. Why do you think that is?

Damian Hoang: The ratio is actually something like three or four covered call funds to one put writing fund. The reason is that it's really easy to launch a covered call fund. An asset manager just have to select a portfolio manager who have track record in investing in US and Canada and tell that portfolio manager, "Can you sell covered calls on a percent of your portfolio, whether it's 25 or 35 or 50 or 75% of the portfolio? Write covered calls on them."

Right off the bat, you have a covered call fund. You literally can lift the existing fund, put it in a new wrapper with some incremental covered calls, and you have a brand new fund that will, in theory, should catch the attention of people who are looking for enhanced yield at this point. The hurdle to launch a covered call fund is I would say fairly low versus launching a put writing fund. To launch a put writing fund, remember you don't actually own the stock, you own cash.

You own cash and somehow you have to turn that cash into something that earn 8, 9, 10, 12% income, have some upside participation versus the market, and have some downside protection built in. All of that from a pool of cash without going out and directly buying stock. Thus, from that, you can visualize how difficult it is to manage a put writing fund. Literally, all you have at your fingertip is a pool of cash and you have to make all of that magic happen.

The reality is that in order to launch a put writing fund, you need to hire specialists. You need to hire talent with proven track record in managing an option portfolio and a stock portfolio that has also expertise in picking stock. When you look at the Venn diagram of where all those circles touch, it's a very small subset. Therefore, it's extremely expensive to hire the talent to run an optimal put writing portfolio. From that perspective, the hurdle to launch a put writing fund is a whole lot higher. The right talent in the US and especially in Canada, really, you can count that on the number of fingers on your hand.

Mark Brisley: In a podcast, we did not too long ago, you discussed the yield of your put writing strategy vis-a-vis that of a GIC. I'd like to revisit that discussion, especially because the majority of our listeners are probably Canadian-based. Also, talking a little bit about tax merits of that discussion as well.

Damian Hoang: I remember just a couple of years ago, we were talking about 5 plus percent GIC literally risk-free. You take your money and you throw it at any of the big banks or small bank and you can get decent income. Those days are gone. In our mutual fund, we were yielding about 6% plus or minus. In our liquid alternative fund, we were yielding about 10% plus or minus. Those yields are still there.

In the DXQ when we launched, it was about 7, 7 and a half percent. That yield gone down a little bit as we discussed because the ETF price have gone up, but it's still just below 6%. The GIC yield at this point, if you lock your money in for one year, I think you get less than 4%. If you're lucky, I think 3.7, 3.8, something like that. If you lock your money in for two years ironically, the number is actually lower. If you lock yourself in for three years, I think it's below 3% is somewhere the GIC certificate should be.

From that perspective, the yields of our funds, including the DXQ are paying out, look, if anything, incrementally more compelling versus what available in the GIC market. Let's not forget the fact that DXQ, since we have that discussion, Mark, the price have gone up by something 20% or more. The GIC that you put in the bank and now have a lower yield, this is the exact same dollar that you're taking out as you put in two years ago.

Mark Brisley: What environments would your strategy DXQ likely do well and what environments would it likely not do as well?

Damian Hoang: A good environment for DXQ is exactly what we have seen over the past two years, where you have a good market overall. There's some pullback. There's a 10% correction here and there, but an overall good market. In that kind of market, you should expect DXQ to provide very robust participation, which it did over the past two years. Per year, DXQ up about 20%. Year to date, DXQ up about 18, 19%.

In the meantime, whenever there's a pullback in the market, DXQ barely participated at all on the downside. DXQ have done well because this is a good environment in an upmarket. Now, in a flat market, let's say if the market going forward, all the return already been pulled forward and everyone hung over and the market doesn't do anything the next few years. DXQ have the ability to collect a lot of gross internal yield by writing cash-secured puts and a little bit of covered calls here and there.

That gross internal yield effectively is think about it as waking up on New Year Day, someone knock on your door and say, "Hey, Damian, I have a check for you. This check is for about 9% performance over the next 12 months for DXQ. Don't do anything bad. By next Christmas, you can cash this check as long as you don't do something bad. Don't get on the naughty list.

Over the next year, if the market stay perfectly flat, all that gross internal yield, i.e. that blank check that DXQ collect, that is a potential a 9% of performance that it would not otherwise have. In fact, I would even go as far as funds that invest in the market would have a tough time collecting that check without having some heroic stock pick consistently. Whereas DXQ, normal course of business, writing cash-secured puts, a little bit of covered call, and the gross internal yield, the run rate of how much income DXQ can collect will get DXQ about 9-10% of income for the course of the year.

In a flat market, DXQ should theoretically be way ahead because of that gross internal yield. Then from that gross internal yield, that is how the distribution on a monthly basis is paid out. In a down market now, this is not a great environment for anyone, including DXQ. If you think about what DXQ does, it write cash-secured on Walmart about 5 or 7% below with the stock trade. It write cash-secured put on Amazon about 8-10% below. It write cash-secured put on Nvidia about 20% below. As a market keeps selling off, the first 7, 8% of sell-off, DXQ start to buy more Walmart.

With the market down now 10%, DXQ will start to buy a little bit more Amazon. Market down 20, 25%, DXQ start to add to the Nvidia position because of all of that of the cash-secured puts that we prior have sold. As the market sell off, initially DXQ should capture very little participation on the downside. As we start adding the Walmart, the Amazon, the Nvidia, eventually we would capture a little bit incrementally more, progressively more in DXQ as the market keep falling. The good thing is at some point when the market bottom, whether it's down 25 or 28 or 30%, DXQ initially capture very little downside, then progressively a little bit more, a little bit more.

Then when the market bottom, DXQ will have the opportunity to have added to its core position of all the stock that it liked, but it didn't want to buy day one. It get to buy those stock a lot lower. Subsequently, as the market recover, DXQ should have more robust participation in the subsequent recovery than it had on the downside participation originally on the way down.

Mark Brisley: I wanted to finish off today's call with some parting words from you, Damian, on what our audience investors should be looking for when they're investing in option funds and ETFs, whether it's through covered calls or put writing as you've outlined both strategies today.

Damian Hoang: The way I think about it is if you have a heart problem and you need heart surgery, you don't go to your family physician. In investing, it works the same way. When you want a very specialized bespoke outcome, you don't just want to have the same PM who manage your American value or European growth to manage your enhanced covered call strategy either. What you want is you want option people with stock selection, stock picking ability with a very good and solid team behind that PM. What you need to do really is you look at track record.

You do not want to buy into an option fund that have the portfolio management team that is only learning the trade. You want to go and look at option fund and consider an option fund that has long track record that you can look at and you can point to and you can really digest how well that option team have done over the full market cycle. Not over the last two years, not over the past three, four years, but over the full market cycle, and if possible, over multiple market cycle. Track record is important and longer track record is better, would be my recommendation to anyone who interested in option strategy.

Mark Brisley: Certainly, and I think I can say this as a final word on behalf of both you and Derek. At Dynamic, we definitely think that all investors are best served with the support and help of a qualified professional financial advisor to help them navigate all of the strategies available to them in the marketplace. If you would still like to do some of your own research, you can feel free to join us at our website at dynamic.ca. I want to thank both Damian and Derek for joining us today and for all of you for listening in to On The Money.

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