First Advisors Capital, Inc. (FAC)
Methodology Overview: Equity Yield Plus
By: Jon P. Lindberg
FAC’s Equity Yield Plus (EYP) is a Dynamic Liquid Alternative (DLA) that uses a proprietary methodology involving options in an attempt to control overall riskand volatility. EYP addresses a critical need in the investment marketplace today. It also answers a common question:
"How can I provide my clients the ability to maintain a consistent low-volatility total return that is generally independent of the equity markets with liquidity, while still protecting their future purchasing power?”
Low Interest Rate Environment
The current low interest rate environment has provided an opportunity for 1) large corporations to issue debt in order to buy back their stock, 2) banks to recapitalize since the Great Recession,and 3) governments to borrow beyond their means. However, at the same time, low rates have greatly hurt investors’ ability to earn meaningful interest or low volatility liquid total returns. This hasforced individuals into higher risk investments (equity markets) in search of yield with no meaningful hedge against the volatility.
With present equity-linked offerings, clients now must tolerate about 15-20% market swings in order to collect a 4% yield, while possibly having totake consistent withdrawals for income through these market swings. To participate in the market, clientsmay be making their deposits during the upper end ofmarket cycles, as well as subjecting their dollars to various global systemic risks — which may cause deterioration of principal if they are also making consistent withdrawals.
Traditional Methods
Listed below are some of the more traditional offeringsfor income and conservative growth methods that attempt to retain future purchasing power. EYP should not be considered a full substitute for these methods, but instead, a compliment to them.
(Please note that FAC is not discounting the usefulness of other methodologies, as they all have their place within a diversified portfolio. These explanations are meant to show the difference between EYP and more traditional methodologies. Due to its conservative nature, EYP may also be viewed as a stand-alonepartial proxy for other, more traditional,liquid interest-bearing asset classes.)
ETF Quantitative / Tactical
Traditional ETF quantitative and tactical disciplines that attempt to provide consistent net returns with low volatility typically fail to avoid large market drawdowns because they attempt to guess the direction of the markets as they place their positions. (This is done using various technical indicators and/or other metrics.)
In order to offer consistent results pursuant to the market itself, these methodologies must implement at least market-weight exposures,as directed by their indicators. These exposures create an environment of uncertainty, since they will inevitably be on the wrong side of the market at various points in time. Over time, these applications maymirror the market (at best) orhave a negative correlation to it when it is on the rise and a positive correlation when falling (at worst).
When these methodologies find themselves on the wrong side of the market, whether due to “false” indicators or periods of high volatility, directional pricing may compound these negative issues. These pricing inequities arise because methodologies typically attempt to “predict” market direction,which may be going down when managers want to sell or up when they want to buy.
High Quality Dividend Stocks (HQDSs)
Traditional income-producing portfolios that are comprised of 60-80% high-quality large capitalization dividend stocks(HQDSs)may provide a portfolio with an annual yield of +/- 4%, while exposing the client to direct market volatility of between 15% and 20% over any 12-month period, based on historical standard deviation and market drawdowns.
Thefact that this methodology is exposed to large market drawdowns(although it hasno real negative correlation to the market itself) also places it outside the realm of independent market correlation. True, dividends are reinvested into more shares at a lower price while the market is downand fewer shares when the market is up.Butdue to this methodology’s long-only mandate, participation in protracted down markets may cause principal liquidation for those taking ongoing distributions or where liquidity is paramount.
Like other long-only methodologies, HQDSs may subject the investor to the “luck of the draw”when it comes to timing, as the timing at which one enters the market has everything to do with one’s end result. For example, a client that enters the market at a lower market cyclewill have a completely different rate of return and account balance history compared to aninvestor who may enter at the top of market cycles.
Individual Bonds
In today’s environment, bonds have become a fear trade, regardless of price or yield.Over the past decade, due to protracted fiscal irresponsibility, both domestic and foreign governments have been implementing quantitative easing. This raises the question of whether there is a correlation between unconventional monetary policies aimed at lowering benchmark-bond yields, and the shifting of investors into a post-financial-crisis landscape where they are encouraged to build large war chests of “safe” securities.
Presently a simple mention of an interest rate movement can cause large price fluctuations in debt that may resultin illiquidity.When the maturity period of a bondcoincides with the investor’s obligation, these liquidity issues carry fewer implications, but the paltry couponsleave much to be desired after tax.
Searching Not for Yield, but for Safety
Bonds are senior to stocks within the credit cycle and have long been the stalwart choice for lower-risk investors and institutions that need some principal-guarantee mandates to meet obligations. But the yields on these safe assets have fallen precipitously.In addition to interest rate risk, bonds also carry credit risks. Despite these risks, some of the lowest-yielding assets have been the best return-generators in recent years, as investors have trumped yield in search of safety. This has caused a total disconnect between yield and return, and one that makes for a dwindling pool of “safe assets.”
Individual bonds can be purchased and held to maturity, where the issuing institution guarantees the return of principal as well as the coupons. However, if rates go up within a bond’s rating and maturity period, the holder may no longer be able to sell the bond for an amount greater than or equal to what was paid, thus causing illiquidity. Not only are the rates for individual bonds very low, but the bondholder’s ability to access his or her principal may be greatly restricted.
Bond Funds
Bond funds,whichgive investors an interest in their underlying holdings, are more sensitive to interest-rate and credit issues due to their perceived higher liquidity and the propensity of market traders to buy and sell ETF bond fundsand mutual funds at the click of a mouse. These traders can quickly liquidate their holdings during periods of interest-rate risk, which may cause reductions in NAV in an increasing interest rate environment.
Traditional Methods Bottom Line
Methodologies that invest enough in the market to “be the market” leave managers attempting to predict intermediate moves as well as protracted bear market recessions — which is a hard business. Harder still is building an investment strategy based on predictions.
FAC believes that implementing prudent options strategiesgreatly reduce direct market exposure, and places the odds in management’s favor as much as possible, pursuant to a greater chance of success, as well as providing managers with the ability to mitigate losses when pricing turns against them.A comprehensive mandated low risk options methodology not onlyallows managers to keep much larger cash position, but also may provide the flexibility needed to reposition or invest after market moves, rather than trying to predict the moves before they happen.
FAC’s Equity Yield Plus (EYP)…. A New Option for the New Normal
EYP’s methodology uses options NOT to maximize returns and leverage, but to LOWER market exposure andthus risk while providing consistent returns, regardless of market direction. This is done by consistently covering both sides of the marketand using options contracts to generate income through cash secured puts on HQDSsand vertical spreads on the SPX Index.
EYP generally does not take a contract position that represents greater than 4% of the entire account value, and in most intermediate market cycles,approximately70% of the account remains in cash until managers deem it prudent to reinvest and “scale in” AFTER each movement regardless of direction.
All attempts to lower risk are a mandated continuum with EYP.EYP onlyuses stocks that meet our criteria of high-quality large / mid cap value that meet our strict fundamental and technical metrics.Account minimums are$250,000, as a 100round lot options contract on these higher per-share stocks dictates larger account balances to stay within our +/- 4% target for maximum exposure per issue.
Same Stocks as Our Long-Only Disciplines Warrant
When selling cash-secured puts onHQDS’s, its management’s goal to not actually own a stock involving put contracts.Only when, after exhaustive mitigation, when actually “put” to a stock, will management own it. At that point, theoverall cost basis generally will be low, as the options premium earned willbe applied to reduce thenet cost basis.
In this scenario, our managers will generally hold the stock long and begin scaling out of the position as it breaks even, thus more risk control. FAC managers only use stocks that would be used in ourtraditional long-only high-quality dividend portfolios, sothe worst-case scenario would be to get “putto” a high-quality stockthat istraditionally appropriate for along position. In other words, the put contracts simply secure prudent pricing, while earning consistent options premiums.
Shorter Market Cycles
Instead of holding a particular HQDS for an entire year to earn a 4% gross dividend (while the account balance swings up and down), EYP’s disciplineattempts to limit stock exposure to amuch shorter market cycle (+/- 30-days per contract) in an attempt to accomplish returns which, in the majority of cases, are higher than the dividend itself and have far less exposure to price movements, both positive and negative.
Not All the Up and Not All the Down
The negative aspect to this methodology is actually what makes it so consistent in both return and volatility control. If the market were to protractedly turn upward,thisdiscipline could not match these upward market movements, even though options premiums may continue to be collected.
On the other hand, if the market turned protractedly downward, the discipline would not directly participate in this movement either, although it may lagif the cost basis of “put to” stocksand vertical spreads mitigations dropped by more than the optionspremiums collected.
Regardless, the discipline’s higher cash holdings would place the managers in a much better position than other methodologies, which may be “all in”or “all out”prior to these protracted moves. EYP lets the market come to the manager, verses trying to predict market movements.
Lower Market Exposure
EYP’s lower market exposure greatly reduces volatility while providing the opportunity for clients to earn consistent returns. Comparatively speaking, a portfolio that is 100% stocks and yields 4% may experience balance movements of+/-15-20% over any 12-monthrolling period(based on current market index standard deviations and historical draw-downs). EYP’s general average market exposure of roughly 30%, would lower these account balance movements to a comparablerange of only +/-4-6% while generating consistent options premiums. This lower exposurenot only lowers volatility, but also provides far more cash to add to the methodology after market movements, regardless of the direction.
EYP’s methodology may not be able to directly match the market’s direct up or down movements, butwill be consistent nonetheless. Consistency without large market drawdowns is very good for long-term results, especially when considering the power of negative returns.
Wrong, While Still Being Right
With options, managers can be wrong on a contract direction and still win, simply becausethey were not wrong enough. In other words, a stock may movedown, but not down low enough to trigger a losing outcome. Managers have the ability tomitigate outcomes by renegotiating the time period of a contract AFTER the contracthas moved contrary to their forecast.
This contract mitigation, or defense, can be achieved by buying back contracts and re-opening them (for a net gain or loss), but most importantly allowing for a longer time period, which maymake it possible for contract pricing to move in favor of the position thus reducing the overall negative portfolio exposure.
Selling Volatility
Options methodologies may also generate additional income from premiums as well as sell/short volatility when it is expensive. As volatility increases (the very aspect that traditionally handicaps other methodologies), the premiums collected from the options may also increase. Again, this is another area where low-risk professional options trading allows managers to let the market come to them versus “predicting” market direction.
Covering Both Sides of the Market
EYP management constantly plays both sides of the market using vertical spreads on the SPX Index. This makes EYP market-neutral,or independently correlated to the market, thus reducing exposure to large market drawdowns or upturns. When there are no large drawdowns or upturns, options allow consistent returns to compound over much longer periods because theymay earn consistent returns regardless of market direction.
No Interest-Rate or Credit Risk
EYP generallydoes not use bonds or bond funds to enhance yield,therefore it does not expose investors to direct interest-rate or credit risk which would hurt liquidity. Nor does it offer direct negative market correlation,which requires guessing which way the market is going to move.Yetit may still offer meaningful long-term total returnsthat actually become negatively correlated to the market, making consistent performance possible. This performance may or may not be greater than the coupons available on individual bonds, thus EYP becomes an excellent enhancement to bond and cash disciplines.
Dynamic Liquid Alternatives (DLAs)
When used as a stand-alone offering,EYPmay be a meaningful proxy for other high-liquidity, low-volatility offerings that are also independently correlated to the equity market but still expose the investor to interest-rate and credit risks. When you couple these attributes with EYP’s liquidity,low volatility, and consistent returns, it may make for prudent fiduciary logic to partially augment EYPinto traditional disciplines to an attempt to counter act their inherent negative attributes.
No one can predict the market, but it is certain to go both up and down. We believe that EYP is a sound compliment for quantitative /technical or buy-and-hold disciplines that attempt to predict market direction or mirror the market. These disciplines have no defense if their managers get things wrong, just terrible pricing when it comes time to exit their positions (or greater volatility for the buy-and-hold discipline). Augmenting EYP within these disciplines means less direct market exposure, thus less volatility, along with more consistency of return and greater liquidity.
No Guarantees
EYP provides no guarantees and there are no guarantees that it will outperform any other investment methodology, however it does provide an alternative to being fully invested at the top of market cycles. It also earns consistent returns regardless of market direction and reduces exposure to large market drawdowns. EYP’s attempted targeted total annual return, net of all fees, is +/- 6-9% annually, although this is not guaranteed.
Helping Clients Understand the New Normal
We must help clients understand that the traditional“risk-free interest earningon bonds and cash”play has been seriously compromised by global fiscal irresponsibility and that this “new normal” warrants pursuing methodologies such as Dynamic Liquid Alternatives like EYP.
Dynamic Liquid Alternatives (DLAs)
EYPis a pioneer in DLAs and, as such,providesadvisors andinstitutions with the ability to apply this proven methodology within their present offerings. The methods that EYPuses are as old as the market itself, but the recipe in which we apply them is uniquely suited to reduce risk and increase liquidity, while meeting conservative income needs.
EYP can provide investors with another option to simply taking a position…as investorsthat add EYP to their clients’ process can now sell options to buy a stock, and oftentimes get paid simply for the opportunity to take or leave a particular position. It is FAC’s goal to bring comprehensive options trading that mandates risk control first to all its investors, large and small.