Aptus Deep Buffers: A Low Cost Bond Alternative?

Full Transcript

Derek

Good Morning. The opinions expressed during this call are those of the Aptus Capital Advisors Investment Committee and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forward-looking statements are not guaranteed. Aptus reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. More information on Aptus’ investment advisory services can be found in this form, ADV Part Two, which is available upon request.

We’ve got JD Gardner, founder of the firm and chief investment officer. We’ve got Brad Rapking, portfolio manager and really has been the driving force behind a lot of the specific tweaks that we’ve made to buffer strategies. We’ve had a lot of conversations, we have a couple webinars on these, just talking through. It’s basically the same structure, we just, we’re taking that significant cost savings that we have offered and applying it into the structure to result in better outcomes for clients.

So that’s what the guys are going to walk through today. We welcome any questions. We got a couple polls in there, just to see what people think about stuff in general. Yeah, appreciate you coming on.

JD

Thank you, everybody, being here. I know we’re probably going to say a few things that we say every time we get together. But we’re excited about these deep buffers. Brad’s going to do most of the talking, but I’ll give you the first, just the highlights of the reasoning for us entering the defined outcome space.

So just a reminder, the first three slides are. Everything we’re doing at Aptus, we’re focused on the asset allocation impact that our strategies and solutions can have. And in a bigger picture, more important point than most of the industry will say is we want to generate higher compounded returns. While everybody focuses on things like sharp ratio, et cetera. The bottom line is can you generate the highest CAGR possible, compounded annual growth rate, with the lowest draw down associated? Because compounded returns leads to higher terminal wealth.

And just a reminder, we go through this simple, simple example quite often. But a million bucks compounded at 10% turns into 6.7 over 20 years. A million bucks compounded at 5%, over 2.6. We have no … The sharp ratio associated with those returns we think matters far less to clients than the terminal value. All financial plans look much better with higher terminal value. So everything we’re doing is designed to generate higher compounded returns.

All right. So with the simplicity and compounded growth rate being the objective, should be the objective for all plans, if you pop into the allocation slide, we talk about this a ton. We are the first to tell you we’re not the smartest people in the room, but if our strategies and solutions can impact asset allocation, we can help move the needle. And the reason that we focused on allocation is because we think it historically has been the biggest determining factor for your ability to growth wealth and protect purchasing power, et cetera. But we think moving forward, really since ’08, this whole industry is relying on bonds to be positive.

This is just a simple, it just shows you what drive returns and it’s the allocation is what matters. Even though headlines, individual equities, fund manager selection, whatever it is, may be more fun to talk about, the allocation impacts it. Specifically, what percentage of your assets are in cash, bonds or stocks? And this is the point that we will continue to make and why we like defined outcome. We like anything that allows a portfolio to have less dependence on bonds because the world assumes bonds will be positive carry vehicles, and I’ll explain that real quick. They also assume that they will be protection against equities.

So the first point to make on positive carry vehicles. We run 7% fiscal deficits. We’ve got … The safety in bonds is an illusion. They are not safe. After tax real is what matters. And on a after tax real basis, fixed income has compounded at negative rates for five years, for 10 years, for 15 years. And this is the Vanguard Total Bond Market ETF, so we’re not trying to get cute showing some section of the bond market that’s been bad. We think your 4% yield or whatever your bond’s yielding right now, number one, it’s taxed incredibly inefficiently. But number two, it isn’t safe. It’s not safe in fiscal, in the backdrop that we have for a number of reasons.

And I do think, for another discussion, but I do think your ability to get out of the BlackRock and Vanguard that we live in and to free portfolios up to compound requires you to own more equities. And we hear you on, “Well, if I own too much equities, my clients can’t handle risk.” Well, that’s where I think the ETF, the options-based ETF space is set to really boom because defined outcome and a lot of the other things that we’re doing, they’re just vehicles to help make this allocation shift, which I think is the most meaningful shift we can make.

So last point that I’ll make is this is what I just said. Can we take a portfolio to inject, if your baseline is 60-40, most operate in risk-based framework, but can we go from the reliance on bonds to owning more stocks and less bonds, but can we do it in a risk-neutral way? With risk being, in our opinion, draw down. That’s what ultimately matters.

So with that said, we do think defined outcome works and we think the deeper buffers are probably even more interesting than the 15% buffers if you’re thinking through them in terms of a pure bond replacement. So take it away, B-Rad.

Brad

Yeah. Thanks, JD. And yeah, I’d certainly highlight, and if you’re interested, we’ve created a whitepaper talking through what it looks like to replace a portion of your bond allocation in a 60-40 type of model with a deep buffer. And I think the data is pretty compelling in terms of the potential benefits it can provide from a compounded return perspective, without injecting that increase in max draw down type risks that we’re always looking at.

So if you want to move to the next slide, JD. I want to just cover, again, what the buffers are doing. So the first iteration we launched last year was 15% buffers. That means you’re protected on the first 15% down. So if S&P starts at 100, you’re protected from 100 down to 85. The difference in the 30% buffers is you’re going to feel the first 4% of the draw down, but then you’re protected on the next 30%.

Why do we do that? Well, the two biggest inputs to any sort of buffered product is looking at what’s your buffer look like, and then solving for the cap. So historically or mathematically, if you’re going to have a larger buffer percentage or coverage, you’re going to have a sacrifice of cap. So we felt by protecting the next 30% after a 4% draw down, it helps optimize or helps improve what your upside cap can be, which is the most important part of the equation. Higher cap, all else equal, leads to higher compounded returns. Where ours differ from peers, traditionally you’re going to feel the first 5% down. So we’re going to have 1% closer of a floor before our buffer kicks in with the same 30% from there. So we feel really strong that the way we have ours set up are going to really help on the downside and protect against those true left-tail type of environments.

JD

Yeah. And I would just stress before popping to the next slide, Brad, all these buffer funds are is they’re ultimately collars. They’re put spreads below the money. So if the S&P’s at 100, it’s put spreads below the money. Some of them 15%, deeper buffer, whatever it is, that’s where the put spread is. And then the cap up top is a short call. So you’re getting the underlying with a collar around it. It is not, despite what a lot of people may say, it is not a complex structure.

Now, how you implement it, there’s some complexity there for tax efficiency and all. But we’re doing just what everybody else is doing in terms of putting in a collar, just the structure of it is a little bit different and the numbers look more attractive on our side. And I think that’s an objective statement.

Brad

Yeah. Thanks, JD. And this is going back, same exact data we showed on the 15% buffer. So this is just looking at if you have a theoretical cap since 1950, what percentage of the time have returns in the market on a rolling 12-month basis exceeded your cap. It goes to show markets historically, a little over half the time are I’d say strong to quite strong and exceeding caps. And as your cap gets higher, you’re exceeding it less. All that does is contribute to higher compound returns. So everything that we’re doing is focusing on how can we improve the structure given our lower costs to be able to hopefully improve on the upside or the downside.

So the next graphic, JD, goes to demonstrate this. Where you can see if you can improve cap from 10 to 11, you’re looking at, historically at least, about 60 basis points of higher compounded returns. So a powerful way of showing higher caps lead to higher compounded returns over time.

And then the next graphic is looking at similar to how we do our 15% buffers, there’s a bit of nuance. This is from our last presentation, but we thought it was still powerful to be able to show. The only difference being, again, our structures are going to be 4% out of the money to start on the buffer, and then we’re going to continue to have the fee differential. The average fee in the space is roughly 78 BPS. Our products are going to be around, at the 25 basis point mark. And then we’re going to continue to spend that 50 basis points on structuring costs.

That means, historically, peers are going to make their collar costless. JD talked about the collar. That means if the put spread costs 10 bucks, they’re going to sell a call that generates $10 of premium. Our case is, hey, we’re willing to spend the fee differential in order to improve cap. So with a 1% tighter floor, our cap’s not going to be as big of a differential. But I think historically, the math will show that our caps will be at a minimum very competitive, but I feel pretty strong that they’re going to be better over time. So you can have now a higher cap, meaning when markets are in the right tail type of environments, exceeding your cap. You’re improving your upside capture, but we also will have 1% better on the floor side. So when the market’s going down or on that left-tail side, we’re going to have 1% better protection there as well.

JD

Yeah. And I do think, Brad, it’s worth spending another minute on we kept this slide because I think it’s the simplest slide that we have to illustrate how we’re getting higher caps with the same buffers. And this is confusing for some reason, but the total cost, just like this slide indicates, the total cost of Strategy A and Strategy B is the same. It’s 80 basis points. Now how you get there is a combination of expense ratio and structuring cost.

So the difference, just to reiterate this as clearly as I can. The difference is when competitors put on a collar, they are doing it in a costless way. Meaning their put spread costs X, they have to go sell X worth of covered costs. Well, if we’re willing to not do a costless collar and to have some form of structuring cost, the amount of structuring cost we’re willing to give up is our advantage of expense ratio being lower. Well, us being willing to spend on the structure is what creates the higher caps.

So yes, we do spend money on the cost, on the structuring cost, but the overall cost is going to be the same. And that’s reflected in the website and all that, but I think that’s important.

Brad

Yeah. And I think the simple example is if the market return is zero over a calendar year period for the defined outcome, our product would be down, in this example, 80 basis points. Competitor products will be down 80 basis points. So all in costs, just to reiterate what JD said, are exactly the same, but the 50 basis points of structuring costs that we’re doing improves returns over time.

JD

Yeah. And if that’s not clear, please, please ask a question. But I think we got a couple more slides. Any questions are welcome because we don’t want you having … The structure and all this is really simple. We understand though that options aren’t necessarily the default language of advisors on a day-to-day basis, but it is for us and so we obviously will answer any questions we can.

Here’s a poll that we thought was worth throwing up here. How are you preserving client purchasing power? So more stocks, gold, commodities, Bitcoin, hedged equity buffered, or keeping dry powder to deploy. 35%, 35%. I think that checks out. We don’t love the dry powder piece. I don’t know if y’all can see the results, but 35% said more stocks. 12% said gold, commodities, Bitcoin. 35% said hedged equity or buffered funds. And 18% said dry powder.

One of the things that I’d point to and I think this is a point we should make. That the nice part about these defined outcome strategies is it’s giving you more S&P beta. And so you’re not taking, why I think you see a lower number on some of the other things like commodities, gold and Bitcoin is there is basis risk or correlation risk that you could be far different from whatever you’re tracking. And we’ve been on record saying, for 13 years now, saying your clients don’t fire you for S&P exposure, which is why our focus in the defined outcome space is in that.

Brad, you got anything to add to that before I pop to the next slide?

Brad

Yeah. And I think I agree that I think that the dry powder is the toughest one. I think we have some compelling evidence that holding cash over longer periods serves as a significant drag on portfolio compounding. And the longer your time horizon is, the higher your odds of holding cash. Under-performing equities I think is an easy one to get, but under-performing inflation’s a little bit more nuanced, but both are really tough to beat.

I think looking at commodities, or Bitcoin or gold, I think can work in a diversified type of portfolio. But like you said, it’s nice to know that you have direct correlation benefits between what you’re protecting against and what you’re owning. I think Bitcoin, gold, commodities can serve as a diversifier in a portfolio, but there’s certainly no guarantee there’s going to be different environments where one works versus the other. Where simply owning an S&P put, when you own S&P beta, the market’s going down, you know that the value of the put is going to help insulate, and go up in value and protect capital.

JD

Yeah. And last couple slides. So we did just a snapshot of the Aptus Defined Outcome Suite. We’ve got four quarterly 15% buffers. We have a ladder of those quarterly 15% buffers to make the easy button in terms of model allocation or whatever. You don’t have to go figure out which quarterlies makes the most sense. And then with these deep buffers we just launched, we’ve got four of them and a laddered version as well. So we’ve got 10 funds total in the defined outcome space, four 15, four deeper buffers and two ladders representing a ladder of each of the flavors.

Brad

Yeah. And to cover what’s going on in the laddered versions on more time, it’s simply equally weighted to each fund. So 25% into each of the quarterly versions. The benefit of that, like we’re trying to highlight there, is one, you’re not having to go in and figure out which fund has the better cap or the tighter floor. We think there could be value there, but this is the, like we have on the prior slide, it’s the easy button to not have to think about it and it certainly helps from a model perspective where you can’t control exactly when capital is flowing in or out of models. And I always like to just phrase it, you’re never more than 90 days or one quarter away from 25% of the fund resetting, like we’re showing there on the ladder. And you’re never more than 90 days away from the next reset.

So it’s a constant reset, highly tax efficient because you’re not having to trade in and out of the individual positions. We’re doing that wrapped inside the ETF structure to be able to keep those target weights online.

JD

Yeah. And we get this question a decent amount, in terms of where are we seeing flows come from. And I think just going back to the poll question, just adding one thought to it is we’re seeing a lot of cash on the sidelines. Defined outcome is really attractive for cash on the sidelines. Because anybody that’s timid about this market, it’s a great way to show protection, defined protection for dollars that are being invested from, quote-unquote, “the safety of cash.”

The other way that we’re seeing it, which is what we advocate for, is, hey, if you’ve got 40% of your book of business devoted towards fixed income, we think that’s an issue. Maybe trim that. Defined outcome, we think, is a pretty compelling trim opportunity just because we think the compounded returns are higher, which is ultimately the objective. And to say this again, if the goal is compounding capital, we think equities have a much, much better chance to compound than fixed income does. So how can you alter an allocation accordingly? We think defined outcome is a great solution to do that.

Brad, you got anything else?

Brad

Yeah. I think one, thanks for everyone jumping on and sticking through some of our technical difficulties to start. But two, I think the whitepaper that we’ve put together talking through how a deep buffer or a laddered deep buffer fund can be a nice compliment or replacement as a portion of your bond portfolio I think is really compelling. So if you’re interested in seeing that, please don’t hesitate to reach out. I think some of the guys on the team did a great job putting that together and again, I think the numbers are really compelling.

JD

Yeah. So hit us if you want to see that. Derek, I don’t know if you’re still there or not, but if you’ve got any closing thoughts?

Actually, D-Hern, let me say this while we’re on the call. On our side, the work that’s gone into these things, everybody here, I know the team has been incredible to get these things up and running the way that we have and to have the flexibility. And who knows if we launch another defined outcome or 20 more, I’m not sure at this point. But Brad, Jason, everybody that’s been involved, Callie, everybody, great work. And it’s fun to be able to talk about these things and have a dog in the fight in the defined outcome space that we think is really, really compelling.

D-Hern, do you got anything?

Derek

Yeah. Sorry about the tech. I went no camera, it seemed to help a little bit, I got a little bit better stability.

Yeah, one thing, too. What the team has done for a lot of people who are either exploring buffers or trying to compare to other products out there, we’re not going to obviously post comps to other tickers on our website because it changes from day-to-day and there’s a lot of reasons for not doing that. But we’re able to run illustrations that can help at least show, whether it’s a ladder or one of the individual quarterly series, help you walk through what the caps might be. It’s obviously pretty consistent that we’re going to see higher upside caps on everything because we are taking those costs, instead of putting them in our pocket, we’re taking that expense and putting it into the structure and making it better.

And so I think running some explicit illustrations is something that the team has been very willing to do. So I would invite anyone that’s interested in doing that, if you’ve got a favorite one you use or a certain series you’re looking at, please just hit us and ask for us to go through that illustration.

JD

And we don’t see any other questions. There’s one on the whitepaper on the replacement, just hit us individually on that and we’ll make sure it’s in your inbox. We do appreciate everybody being here. Hopefully, this is helpful. And as the defined outcome space grows, we’ll try to get … We’re making a push towards more collateral and more messaging and content to where the cap data, the benefit of higher caps, the ability to compound through defined outcome, the issues with fixed income, we’re trying to do as good as we can to get as much content out there as possible so we can answer questions before they come up.

Brad, any closing thoughts?

Brad

Appreciate the time, everybody. Thank you.

JD

Thanks, everybody, for joining us.