June 27, 2024


June 27, 2024

Active ETFs: Strangers with Boomer Candy

Growing up, one of the first things we are taught is not to let a stranger lure us into a van with promises of sweet treats. Predators have a keen sense of exactly what their victims desire most. They use that to take advantage of them.

When it comes to investing, these early life lessons can come in handy.

A few days ago, The Wall Street Journal published an article titled These Hot New Funds are ‘Boomer Candy’ for Retirees which describes the latest sweet treats coming out of the asset management chocolate factory.

Thanks to recent regulatory reforms that permit actively managed Exchange Traded Funds, or “active ETFs,” to engage in complicated derivative transactions, investors now have a whole new set of temptations. And they are going for them—to the tune of over $30 billion in just the last 12 months.

While the promised payoffs of many of these active ETFs sound delightful, we strongly advise 76report subscribers to do what you might do with your kid’s Halloween candy collection—inspect it carefully.

Better yet, don’t eat it at all.

Boomer Candy

So-called active ETFs are now putting derivatives to work as they promise some variation of guaranteed returns and/or above-market rates of income generation.

We are not surprised that investors (especially baby boomers who are in or approaching retirement) are interested in getting the benefit of stock market upside, without taking material downside risk. Or that they want investments that generate unusually high income streams relative to traditional income products.

We are also not surprised, some fifteen years later, that investors seem to have forgotten the most important investment lessons coming out of the Global Financial Crisis.

The first lesson was that when something seems too good to be true, it probably is.

Bernie Madoff famously promised investors that he could provide them with market rates of return (or better) without taking any real risk. Before he was charged in 2009 with defrauding his victims of some $64 billion through his Ponzi scheme, Madoff reportedly told investors they could expect a consistent 10% to 12%, which he was able to deliver through fabricated financial statements.

It is very much worth mentioning that the strategy that Bernie claimed drove his enviable risk-adjusted performance was known as covered call writing. Involving the sale of “out-of-the money” call options on stocks owned within the portfolio, this is the exact strategy being advertised by some of the new ETFs.

Bernie understood that the complexity of derivatives gave him cover to get away with making unrealistic promises. No doubt, many of his victims said to themselves, “Don’t worry, he’s a financial expert, he understands these things.” Because his promised returns appeared at least somewhat reasonable, if a bit high given the presumed lack of downside potential, they allowed themselves to be deceived.

The second lesson of the 2008 financial crisis was, quite simply, that derivatives can be very dangerous. As history has taught us, derivatives tend to work better in theory than in practice. And they have a pronounced tendency to fail at the exact moment you need them most, when markets are collapsing and becoming dysfunctional.

This is the real irony (and perhaps future tragedy) of offering downside protection products that rely on derivatives. Derivative trading always seems to go haywire when markets become illiquid, the stability of financial institutions is threatened, and investors are in panic mode.

These are not your grandfather’s ETFs

Unlike the ETFs that investors have come to know and love over the past three decades, the ETFs profiled in the Journal article are actively managed. Despite this critical distinction, they likely still benefit from a positive perception of ETFs in general, thanks to the excellent long-term results generated by well-known passive ETFs. These include the SPDR S&P 500 ETF Trust (SPY), which tracks the S&P 500 Index, and the Invesco QQQ Trust (QQQ), which tracks the Nasdaq 100.

SPY was in fact the first ever ETF in the United States. Investors who bought SPY on its first day of trading in 1993 likely don’t have many regrets. SPY has compounded at over 10% per year over the last 31+ years, which translates into a 2,100+% total return.

Put differently, on a gross basis (excluding the effects of taxes on dividend or capital gain distributions), a $10,000 investment in SPY is now worth more than $220,000. (A healthy reminder that when it comes to the stock market, patience is your friend.)

Total Return of SPY since 1993 Inception

Passive ETFs have worked over long periods of time because the stock market tends to work over long periods of time. They involve no leverage, no derivatives, and really no decision-making. They were developed as hyper-efficient tools through which investors can own the stock market, or various portions of it, rather directly.

Active ETFs are entirely different creatures. It is important not to let the perception of safety, predictability, efficiency and performance that passive ETFs have earned over the decades extend to active ETFs, just because they have the same name.

To be clear, an active ETF is just like an active mutual fund, except it offers investors liquidity during the trading day. Active ETF managers are not trying to replicate the performance of a particular index. They are using their own judgment and buying and selling securities to achieve whatever financial objectives they are pursuing.

Active ETFs therefore have all the same defects as active mutual funds. And for all the same reasons, you might expect them to involve the same risks and performance challenges as active mutual funds.

It would be bad enough if the new active ETFs that have come to market resembled the more “plain vanilla” actively managed mutual funds that investors have been abandoning for years. But if they did, who would buy them?

To solve that problem, Wall Street has returned to its old toolkit, or better yet, makeup kit. Active ETFs needed to be differentiated from the plain old underperforming active mutual funds nobody seems to want anymore.

So complicated derivative strategies have made a comeback. Derivatives are the lipstick on the active ETF pig.

The sordid history of derivatives

Derivatives are financial agreements that provide investors with highly leveraged exposure to the performance of certain financial instruments and commodities. Sometimes referred to as options, their value usually goes up or down a lot if another security or index goes up or down a little.

In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. - Warren Buffett, Berkshire Hathaway Annual Report, 2002

Derivatives have played a leading role in nearly every financial crisis in recent memory.

In October 1987, “portfolio insurance” (which resembles the downside protection mechanism promised by a number of these new active ETFs) was the reason we had Black Monday. The Dow Jones Industrial Average collapsed 23% in a single day, in no small part because of operational snafus associated with derivatives strategies that were designed to limit investor losses.

About a decade later, the Nobel Prize winners associated with hedge fund Long-Term Capital Management (LTCM) nearly brought down the global financial system with highly levered bets that utilized derivatives. In 1998, the Federal Reserve Bank of New York had to organize a $3.6 billion bailout of LTCM to prevent financial contagion.

Last but not least, we had the “Lehman shock” and ensuing Global Financial Crisis (GFC) of 2008, which made the LTCM debacle look like child’s play.

Derivatives contributed to the GFC in multiple ways. The entire sub-prime mortgage bubble was precipitated by complex financial structures known as Collateralized Debt Obligations (CDOs). These “synthetic” financial instruments even had their own special derivatives, known as “CDO squared,” that allowed speculators to make levered bets on their performance.

Wall Street “innovations” around sub-prime mortgages led to losses that a large group of financial institutions could not endure. But one of the main reasons this metastasized into a globally systemic crisis is that all of the affected financial institutions had outstanding derivative contracts with other institutions.

So derivatives were not only the initial reason the Global Financial Crisis developed (the sub-prime problem), they were the reason the financial system as a whole almost crumbled after Lehman Brothers collapsed (counterparty exposure).

Black box risk

As we read about the various new active ETFs that promise to limit downside losses through the implementation of derivative strategies, our first reaction is that there is often a gap between an intention to deliver a certain outcome and the reality that unfolds.

In the Wall Street Journal article, there is reference to one ETF in particular, which is offered by Calamos Investments. The goal of this ETF is to provide upside exposure to the S&P 500 (subject to a cap) without loss potential.

Calamos’s S&P 500 Structured Alt Protection ETF, for example, is designed to match the S&P 500’s return over one year, with gains capped at 9.8%. In exchange, investors who hold for the full outcome period are protected from capital losses entirely. The fund charges a 0.69% annual fee on assets, which is much higher than passive funds that track the S&P 500 but in line with other actively managed ETFs. - Wall Street Journal, 6/23/2024

If there were ever a time to read the fine print, it would be before purchasing an active ETF that promises to protect investors from losses through complicated hedging techniques. Investors need to understand, while an investment manager might aim to deliver a certain result, you generally have no legal recourse if it does not work out as hoped.

When it comes to complicated investment products, the intentions tend to headline the marketing documents. The explanations as to how and why these intentions might not be fulfilled are usually buried in the legal disclosures.

While the Fund seeks to provide 100% protection against losses experienced by the Underlying ETF (before fees and expenses) for shareholders who hold Fund Shares for an entire Outcome Period, there is no guarantee it will successfully do so. If the Fund’s NAV has increased significantly, a shareholder that purchases Fund Shares after the first day of an Outcome Period could lose their entire investment. An investment in the Fund is only appropriate for shareholders willing to bear those losses. There is no guarantee the capital protection and cap will be successful and a shareholder investing at the beginning of an Outcome Period could also lose their entire investment. - Calamos Investments, Summary Prospectus, 5/1/2024

“Synthetic” income

In addition to downside protection, some active ETFs use derivative strategies for purposes of income generation. This is not at all new, although the ability to put capital into a “covered call” strategy through an active ETF is.

We are quite familiar with the techniques used by certain income funds to generate income by selling calls. We have never applied any of these “synthetic income” strategies but have sat in many meetings with representatives from leading investment banks who wanted to provide these services.

The way it works is fairly straightforward. A “call option” is an agreement to forfeit the upside (either on a specific stock or an index) if the price goes beyond a certain level during a defined time frame. Because you are giving away the possibility of unlimited upside, you receive something in return, which is known as “call premium.”

While funds, including ETFs, can distribute the proceeds from selling calls as dividends or distributions, and such distributions may be characterized as “income” for tax purposes, is that really income? Or are you simply selling the potential upside of your investment, while continuing to bear downside risk?

When it comes to income generation, we prefer the real thing. Actual cash flows that are generated by an actual business and then delivered to shareholders. If you are interested in income generation strategies, we encourage you to explore our Income Builder Model Portfolio, which is linked below.

Why Wall Street prefers active strategies

It may not come as a complete surprise that the reason the investment industry generally has a strong desire to promote actively managed investment vehicles is that they make more money. A lot more.

Passive investing has in fact become one of the asset management industry’s biggest challenges. As passive strategies have gained acceptance and market share and become even cheaper over time, it has led to fee compression across the board as active managers struggle to justify their value proposition.

Mutual fund fee compression

The key problem is that passive investing, as we discussed at some length in our Guide to Independent Investing, has worked quite well. Few active managers are able to outperform passive strategies over long periods of time.

One of the reasons passive strategies have performed so well, especially in recent years, is that they tend to be based on market capitalization weighted indices. The outperformance of the very large capitalization stocks at the top of the index holdings list, such as NVIDIA (NVDA), Microsoft (MSFT) and Apple (AAPL), each of which now represents some 6% of the S&P 500 Index, has benefited passive strategies. Active funds do not usually have such large allocations to individual holdings.

NVDA in particular has really been a problem for active management over the last few years and certainly in 2024. While many active fund managers have had NVDA exposure, these would mainly be growth or tech funds. Generally speaking, one would not find as large allocations to NVDA in actively managed large-cap U.S. equity funds as what we see in the index.

The importance of NVDA to the total return of the S&P 500 is hard to overstate. Even stocks like MSFT and AAPL, which have delivered total returns over the past three years that were more than double the return of the S&P 500, seem like modest outperformers when presented in a chart alongside NVDA.

If you are interested in understanding NVDA better, we encourage you to read our recent 76report discussion and/or watch our video conversation below.

NVIDIA: Buy or Sell? Trish Regan, Rob Hordon Weigh the Risks and Rewards

NVIDIA: Buy or Sell?

NVDA’s wild success, which has been captured by market cap weighted passive strategies, has made matters worse for the active management industry. But the superior performance of passive alternatives has been a long-term headwind.

The US large-cap market has been particularly challenging for active managers due to its competitiveness and representative indexes. Just 12% of them survived and beat their average passive rival over the decade through December 2023. - Morningstar, Active vs. Passive Funds by Investment Category, 3/21/2024

The emergence of active ETFs should be understood in the context of what is arguably a position of desperation for the active fund management industry.

The ESG precedent

This is not the first attempt by the asset management industry to “innovate” its way out of the passive fee compression dilemma. The industry made a big push for ESG (Environmental, Social, Governance) and “sustainable” funds, especially around 2019.

Riding the coattails of the global green movement and other political initiatives, the asset management industry embraced ESG funds as a strategy to justify charging clients higher fees.

Sometimes they would position ESG as a sophisticated form of risk management. Alternatively, elevated fees for ESG products would be justified by the idea that your portfolio manager has been promoted from mere stock-picker to high priest of moral virtue. Sure, you were paying more, but active management was now necessary to differentiate which companies were good or bad for humanity.

To the consternation of the asset management industry, ESG is not quite working out as hoped. One of the main problems is that the traditional energy stocks that ESG managers said everyone needed to hide from have actually performed quite well. Over the past three years, energy stocks have significantly outperformed the S&P 500, notwithstanding the contribution of large-cap tech stocks to the total return of the index.

ESG failed to deliver on its promises of superior performance. People have also caught onto the political agendas inherent in the ESG movement, which conflict with many traditional American values, principles and priorities, as we have discussed. Fund flows into ESG-type strategies peaked in early 2021 and have gone down ever since. They have generally been negative since the second quarter of 2022.

Our preferred approach

At 76research, we like to keep things as simple as possible. We like to minimize fees, minimize tax burdens, and minimize risk factors. To some extent, this involves avoiding active management products altogether, not just active funds that use derivatives.

One of the main problems with actively managed funds is that you truly never know how it will be managed and what you will own in the future. While you may like or trust a given fund manager at a particular time, things change. Portfolio managers and analysts move from shop to shop. Fund management companies themselves experience changes of control and often change their stripes. Sometimes, funds take on entirely new investment objectives if they are not raising assets.

Our Model Portfolios offer investors a resource to develop direct ownership of stocks, without paying fees to an ultimately unpredictable middleman. The stocks we recommend within our portfolios are intended as buy-and-hold investments that can be paired with long-term allocations to low-cost passive funds, which provide broader market exposure.

One of the main attractions of the new breed of active ETFs is the opportunity to limit downside risk. But by investing in such vehicles, even if they perform as intended, one is forfeiting one of the main reasons to be invested in stocks in the first place—the opportunity to compound over time with open-ended returns.

In 13 of the past 20 calendar years, the S&P 500 delivered annual returns greater than 10%. In 5 of those years, returns exceeded 25%.  

Managing downside risk

Investors concerned about losing money in the stock market have options to address this without relying on expensive and potentially dangerous derivatives-based strategies.

First, there is diversification within your equity allocation. Put your eggs in multiple baskets. Have broad-based market exposure, and diversify your individual stock holdings across companies and sectors.

Second, when you invest in stocks, only invest up to an amount where a bad market development would be tolerable, if undesirable. You may wish to keep some portion of your portfolio in lower risk investments, like short-term government bonds, which can be used as dry powder in the event of a stock market downturn.

Third, consider an allocation to gold-related investments and long-term Treasuries, which may perform well if the stock market performs poorly. Many investors consider these hedge assets, with the idea that they can be sold profitably in times of market distress, generating cash that can be redeployed into stocks that are trading at lower prices.

Wall Street firms will always be there to tempt investors with new gimmicks and strategies, or old gimmicks and strategies in fresh packaging. Not all of them will result in disaster. But what might make a lot of sense for Wall Street firms does not always make a lot of sense for the individual investor.

The nature of any human being, certainly anyone on Wall Street, is “the better deal you give the customer, the worse deal it is for you.” - Bernie Madoff

Rather than go for complicated products with slick marketing and tantalizing promises of exceptional risk-adjusted returns, investors should stay focused on the tried and true methods of achieving long-term financial success.

Spend your time learning about businesses to figure out which ones will serve you best in the long-haul. Consistently put money into the market. Use dollar-cost averaging. Have patience. Learn to accept some volatility and even welcome it as a buying opportunity.

No one wants to lose their hard-earned money. But there is unfortunately no reliable way to benefit from the enormous long-term upside potential of the stock market without bearing some form of downside risk. The reality of that statement will not stop others from trying to convince you they can deliver that very appealing outcome to you—for a nice fee.    


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