Lazarus: To be a moron.

Speedman: Yeah.

Lazarus: To be moronical.

Speedman: Exactly, to be a moron.

Lazarus: An imbecile.

Speedman: Yeah.

Lazarus: Like the dumbest dude that ever lived.

Speedman: When I was playing the character.

Lazarus: When you was the character.

Speedman: Yeah, as Jack, definitely.

Lazarus: Jack, stupid Jack. Trying to come back from that.

Speedman: In a weird way it was almost like I had to sort of fool my mind into believing that it wasn’t stupid, and by the end of the whole thing, I was like, “Wait a minute, I flushed so much out, how am I gonna jumpstart it up again?” It’s just like… Right?

Lazarus: You was farting in bathtubs and laughing your ass off. Yeah. But Simple Jack thought he was smart, or rather, didn’t think he was stupid, so you can’t afford to play stupid, being a smart actor. Playing a guy who ain’t smart but thinks he is, that’s tricky.

Speedman: Hm. Tricky.

Lazarus: It’s like working with mercury. It’s high science, man. It’s an art form.

Speedman: Yeah.

Lazarus: You an artist.

Speedman: Hm. That’s what we do, right? Yeah.

Lazarus: Hats off for going there, especially knowing how the Academy is about that stuff.

 –Tropic Thunder (2008)

As I type this, I’m looking out the window of the new Aptus headquarters where the heaviest snowstorm in over a century is falling with remarkable volume. I suppose that is fair karmic payback for leaving my wife alone with the kid and dog in the arctic environs of the northeast. Still, since I’ve joined Aptus back in May, I’ve quickly come to adopt Fairhope as my home away from home. It’s a wonderful town, with even better people. When I rolled into town on Sunday, I swung into McSherry’s to catch the second half of the Eagles game where I had a great conversation with one of the locals, Bryce, who was sitting next to me. While Saquon Barkley got past his lead blockers to take his now iconic run into the endzone, Bryce asked me what I did for a living. When I told him, he immediately wanted to talk crypto.

Bryce had a very interesting view on crypto that I have to say I heartily agreed with, he flat out stated “I’m a trader, not an investor. If I was an investor, I’d just buy Apple or Coke. With crypto, I trade it. I don’t invest in it. I know I’m being a bit of a degenerate doing it but I’m always thinking about how I can get my money out the door if I need to.” Honestly, yes, that right there. Bryce has got it figured out and he also inspired this missive. A great trader always knows where their exit liquidity is. If you’re going to be in crypto, a little bit of degen behavior is fine, just don’t ever go full degen.

What is full degen? Full degen means you naively think price rocketing up is a sign of strength and that cryptocurrency is actually currency. I have zero qualms if you’re trading like Bryce, I say more power to you. It is risky sure and could accurately be called gambling, but if you are thinking through your max profit and making sure you can get your money out when you need to…that ain’t full degen. Unfortunately, the legacy financial media, what Marc Cohodes accurately describes as the Cartoon Network, reinforces the full degen mindset. In my deservedly humble opinion, that has harmed a large number of investors chasing those ever elusive returns. My little rant here is my best attempt at public service.

Let’s address the most important point up front, the monetary terms that are thrown around in relation to crypto are a red herring. Terms like memecoins, stablecoins, cryptocurrency, etc. are just misdirection. These are simply digital tokens that are traded on unregulated exchanges. That’s it. They are not money. Money is a legal framework that allows for the settlement of debt. As a US citizen, my debts are denominated in dollars. I pay my mortgage in dollars, my taxes in dollars, and my son’s school in dollars. The only reason I would get into crypto would be to hopefully pull more dollars my way. The entire crypto universe revolves around the dollar. If you’re buying into the hype that somehow any of this stuff is going to replace the dollar, you just went full degen. It is the other way around.

Now the argument is often made that crypto can be an effective tool for someone in a country that is experiencing hyperinflation and needs some way of protecting their wealth. I won’t argue that point, if I was a Turkish or Venezuelan citizen, I’d likely be desperate enough to try anything. My contention though would be that if I was in that situation, my thought process would be that crypto is an end around for me to get into the dollar system via stablecoins like Tether or USDC if I can’t access dollars in my home country to get relief. Crypto needs the dollar. The dollar does not need crypto.

Which brings us to our next important concept that our own Brian Jacobs beautifully illustrated in a recent blog post. Namely, that crypto has not created one penny in new wealth. Hear Brian now, believe him later. Have some people gotten rich from crypto? Absolutely, but the overall wealth in the economy did not change. The amount of dollars held in the economy stayed the same, one person exchanged those dollars for crypto and the other person sold the crypto. The cash does not change. Cash is like matter, it cannot be created nor destroyed. Only God has the power to create or destroy matter and in the case of the economy, God happens to be the Fed and the US Treasury.

Money is created in the US economy via lending. The government issues bonds and those bonds pay interest which goes into the pockets of the bond holders. The interest payments reflect true money creation. Mortgages are another example of this. When you buy a home, you give your down payment, and the bank creates the rest of the money which goes to the seller. That loan is new money and is actual wealth creation for the person selling the home. That is how the system works. To the argument that nothing backs the dollar since we went off the gold standard, allow me to introduce you to SEAL Team Six. What would you rather have to back your currency? A hunk of metal or five aircraft carrier groups and the nuclear arsenal?

Why does this matter for crypto? It speaks to another aspect of the space that is often misrepresented on the Cartoon Network, namely that a rising price means that the underlying asset is getting stronger. Nope, it is in fact the other way around. The higher the price goes, the greater the price fragility of the token. Remember, as crypto values go up the amount of dollars in the system relative to crypto stay the same. Which means that it gets increasingly difficult to sustain liquidity as prices go higher. If you fail to recognize that dynamic, you’re setting yourself up for FOMO buying which never ends well.

One of the things I see all over financial social media are statements such as “If you had just bought $X of X coin on this date, you would have *insert ridiculous number here* today.” Nope, that is not even close to being right. Let’s paint the picture of the perfect scenario for you. Imagine that you had the stomach to throw your 401k at the Moo Deng coin last September, call it $250,000, and by some miracle your spouse didn’t divorce you. Today that would be worth over 583 million dollars…right? Unfortunately, that is very wrong. You couldn’t go and just dump that much Moo Deng without crashing the price. Unless you know someone that has 583 million dollars and wants to be your bid, you’re stuck. You’re going to find yourself with a Sylvester the Cat problem. Namely, stranded on an island with more canned food than you could ever eat…if only you had a can opener. Unfortunately, we see so many investors plowing into crypto in the hopes of getting inordinately rich without ever considering how they are going to get that money out.

While this piece is meant to shatter a few myths around crypto, it is not meant to state that there is no reason to invest in the category at all. If you’re like my friend Bryce and have a well thought out process and risk controls in place, far be it from me to tell anyone how to make a living. Rather, we want to arm investors with some key concepts to think about some of risks in naively trading in an unregulated market. If they’re not thinking through their position sizing or how they are planning to exit back into the dollar system, they’re going full degen. Remember, all of this is incredibly hard. It isn’t supposed to be easy. If you’re going to play a zero-sum game, always bear in mind that if you can’t spot the degen at the table, you are the degen.

 Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2501-42.

The post Never Go Full Degen appeared first on Aptus Capital Advisors.

More importantly though, people often underestimate their own experience. If you’re in any way managing your family finances, then you have experience with options. Probably in a different language, but the practical applications of the concepts are identical. Here we’ll cover some very basic options trades and how you are already making those trades in your day-to-day financial life.

Long a Put

A put option is the right to sell a specific number of shares of stock at a stated price over a given period. Going long a put (or buying a put if you prefer that) is essentially term insurance against a stock losing value beyond a specific price point. Put buying is one of the first things you do as you become financially independent. For instance, when you get your first car you will need to insure it. Insurance protects the equity you have in the car should you get in an accident. In the event of an accident, you get a lump sum payout from the insurance company.

The beauty of the arrangement is that you can take small known losses (the premiums) to protect against the catastrophic unknown loss of having to buy an entire car at an unexpected time. This is not at all different from taking the proceeds from a long-put position, and buying more stocks when the market declines.

The same is true with life insurance. Your ability to earn an income represents the equity of your own human capital, and the income you receive can be thought of as dividends from that equity. Apologies for being morbid, but if something were to happen to you, the equity value of that capital immediately goes to zero. If you have a family relying on that capital to maintain their standard of living, it represents a loss that is unrecoverable.

Life insurance is essentially an “at-the-money” put on your human capital. That is why whole life insurance is so expensive, you are asking the insurance company to sell you a put option that never expires. When you were considering term vs. whole life along with all the other considerations that go into that purchase, that is conceptually no different than an options trader trying to figure out the best hedge for their portfolio along with the most appropriate cost.

Long a Call

One of the clearest examples of a long call option is the “earnest money deposit” that you make when going through the home buying process. When you make an offer on a home and the seller accepts that offer, the 1-3% deposit you make prior to closing is like a call option. It has a strike price (sale price) and an expiration date (closing date). Let’s say that during inspection there are issues with the home that are uncovered, and you no longer wish to buy the home at your original offer price. If you walk away, you only lose your deposit. How is that any different than a call option on a stock that failed to go “in the money”? The earnest money deposit is the right but not the obligation to buy a home at a stated price by a stated date. If you ever bought a home, you were trading a call option.

Short Calls and Puts

Changing course a bit, let’s talk about being short options and how that looks in your financial life. Intuitively, being long options makes more sense for most, since we are typically looking to reduce risk in our financial lives and create more certainty. One of the challenges of being the option seller is that someone else is paying you premiums for to accept the risk for the entire given period.

What is critical to understand when you are selling options is that your approach to risk management must evolve. Long options have a risk management feature already built into them; your maximum loss is capped at the premium. On the other hand, when you are short an option (or selling the option), your potential losses are much larger than the premiums or income that are coming in. Risk management becomes imperative in that scenario.

This is what made the 2008 mortgage crisis so problematic. The largest financial institutions in the world put on the exact same trade, they sold out of the money puts on the U.S. mortgage market and then leveraged that trade massively because their models told them that those puts could never go into the money. Yes, it really was that stupid. When those puts went in the money, life got…interesting.

At this point you are likely understandably thinking: “Ok, got it, I should only buy options because selling them sounds really scary.” Yet there are meaningful advantages to selling options, provided that you understand how to manage your risks. Selling options delivers consistent income and when you retired, your portfolio might transition from one that looks like a “long calls” portfolio to one that looks more like a short call and puts portfolio, or a “short straddle” if you want to sound more technical.

Moving from growth stocks to dividend stocks is an example of going from long calls to selling calls. The dividends give you income now, and you accept the tradeoff that your upside on those stocks will be somewhat capped. On the short put side, if you ever got a savings bond as a kid or have a target date fund in your 401(k) then guess what, you are selling puts.

A bond is functionally a short put trade. If you are buying Treasuries and investment-grade corporate bonds, you are managing your risk since there is a low likelihood of those puts going into the money. The compromise is that you will not receive a very high premium for doing so. However, if that premium is sufficient, then taking on additional risk for a bit more income isn’t going to make a whole lot of sense. This is exactly why investment opportunities that are sold on income that sound too good to be true should be greeted with a great deal of skepticism. Remember, if you do not understand the yield then it is a pretty good bet that you are the yield.

 The world of options trading may seem intimidating at first, but it becomes much clearer when we recognize that many of the concepts are already present in our everyday financial lives. From buying car insurance to making earnest money deposits on a home, these are all practical examples of options in action. Similarly, even the more complex strategies, like selling options, have parallels in common financial activities like investing in bonds or managing dividend stocks.

By acknowledging these connections, it becomes easier to see that we all engage with options, often without even realizing it. Whether you’re hedging risk or seeking income, the core principles of options trading mirror decisions many of us make daily, allowing us to approach the world of options with greater confidence and understanding.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward-looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2501-5.

The post You’ve Always Been an Options Trader appeared first on Aptus Capital Advisors.

For the uninitiated, Formula One racing is highly entertaining. Netflix’s Drive to Survive is a fantastic way to get introduced to the sport and has been quite the crowd pleaser when my wife and I can’t figure out what to watch after both our toddler and dog have finally called it a day. Essentially these are some of the fastest racing vehicles on Earth and the engineering/precision required to drive the cars to their absolute limit is thrilling. Along with that, the politicking and drama between the teams is completely over the top and hilarious. Yes, we are going to talk options Greeks, but we are going to try to have a good time doing it.

First, what the heck is a “Greek”? Greeks come from the Black-Scholes model which was first posited to price options back in 1973. Myron Scholes, Fischer Black, and Robert Merton were awarded the Nobel Prize in Economics in 1997 for their work in this area. The model sits at the heart of how market makers price options, and the Greeks are the individual components to that pricing. There are five main Greeks that can be used to examine the current pricing of an option: Delta, Gamma, Vega, Rho, and Theta. Granted there are many secondary Greeks like Vomma, Vanna, and Charm but we’ll leave those to the people that really enjoy rabbit holes. From here, we’ll use Formula One analogies to hopefully demystify these components to help people better understand how their positions are impacted by market movements.

Delta

Delta measures the change in the price of an option given a $1.00 change in the price of the underlying stock. Delta is positive if you are long a call option and negative if you are long a put option. If you were in Lando Norris’s McLaren, delta would measure the change in speed of the car given the amount of additional pressure you put on the accelerator (calls) or brakes (puts). To put it simply delta is looking at change, and once an option goes “into the money” (the stock goes above the strike price on a call or below the strike on a put), delta then just sits at 1 (or -1 for puts). The way to think about that is akin to the ultimate top speed of an F1 car, once reached the car cannot go any faster no matter how hard you press on the gas.

Gamma

Ok, we cheated a little bit here because technically gamma is a “sub-Greek” off of delta but we’ll set that aside as gamma is critical to understanding the price behavior of options. Gamma measures the rate of change in delta for every 1$ move in the underlying stock. Think of gamma as the rate of acceleration in Lando’s McLaren, where delta measures the change in speed from say 150mph to 200mph (so the delta is 50mph), gamma is measuring how quickly that change occurred. Balancing gamma and delta in an options position is akin to figuring out the proper balance between acceleration and top line speed on a racetrack. Some F1 teams prefer to maximize top line speed (delta) and win the race on the straightaways while other teams may be willing to sacrifice top end speed to gain acceleration (gamma) and seek to out race their opponents on the turns. Both approaches can win, you just need to know which style works best for you.

Vega

This one is measuring the option price’s response to a change in the volatility market makers are pricing into the option. If vega is increasing, that will benefit the person who is long the option. Why? Because if volatility is going up then the option has a greater probability of finishing in the money. In an F1 race, vega would measure the number of crashes that are occurring. More crashes are better for the vehicles that escape because you are now racing against fewer cars and are more likely to win. Formula One tends to have a couple of teams that dominate each year with the lesser teams much less likely to win a given race. If there are fewer crashes (low vega), the dominant teams have a much higher probability of winning. On the other hand, crashes inject a good deal of uncertainty, and a high vega race gives the lower teams a much better shot at ending up on the podium. Think of options sellers like the Red Bull or Mercedes teams, most options expire worthless, and options sellers usually just collect their premiums (win) and move on. However, if volatility (vega) suddenly blows out then you have a scenario where those who purchased the option suddenly find themselves with a tidy profit. One unexpected way vega impacts options are scenarios where market volatility picks up dramatically, markets crater out, and yet if you own long calls they aren’t falling as much as you expected they would. That is because volatility is high, and your call still retains enough of a chance to finish in the money therefore the position still retains some value.

Theta

Theta measures the impact on price as an option moves closer to expiration. If you are an option seller, theta decay is positive for you as your short position has less time to go into the money. If you are a buyer, the more time you want to have in an option position, the more you’ll have to pay. Theta is negative for you, as you move closer to expiration then less time is embedded in your option. That reduces the probability you finish in the money, which reduces the ultimate value of the position. If Max Verstappen is leading the Monaco Grand Prix, then Max would prefer to have fewer laps left to the end of the race as that increases his chances of finishing P1. If you are George Russell in the Mercedes trying to catch him, you would want as many laps as possible to increase your odds of an overtake.

Rho

Ok, last one and kindly note that we kept our promise of no math. Rho measures the change in the price of an option given a 1% change in interest rates. Rho has a greater impact on longer dated options and is much less important for shorter dated options. Think of rho as the overall conditions on the track. When track conditions are such that the tires are worn out more quickly, that increases the number of pit stops necessary to complete the race and potential tire blow outs. High rates (rho) mean rougher track conditions. That doesn’t impact a 10-lap race all that much, but if we’re talking about 60-laps then your team needs to be very thoughtful about which tires to put on the car at the start and how many stops they plan to execute throughout the race.

Hopefully this piece has been somewhat helpful in demystifying how to think about options positioning in a portfolio. Unless you are actively trading an options portfolio yourself, you really don’t need to worry about the math. As with F1 racing, mastering options trading requires a deep understanding of the underlying mechanics, constant adaptation to changing conditions, and a strategic approach to risk management. Ultimately, while options trading may seem as daunting as piloting an F1 car at breakneck speeds, with the right knowledge and tools, investors can navigate this complex financial landscape with greater confidence and precision.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward-looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2411-12.

The post Learning Greek, with a Formula One Translator appeared first on Aptus Capital Advisors.

In the NL Wild Card round, something happened that has never happened before in the history of Major League Baseball. Pete Alonso hit a series-deciding home run that flipped the lead from the Milwaukee Brewers to the New York Mets in the 9th inning of the deciding game in the series. In 121 years, that has never happened before. What is amazing about any elite hitter is the unique combination of both urgency and patience. They must have the patience to analyze the pitcher, the situation, and not act too early when every competitive instinct they possess is screaming at them to swing out of their shoes. At the same time, when all the preparation and patience have come together to put the hitter in a situation where they are going to get that one pitch, they must have the urgency to act with controlled violence and bring bat to ball.

There is a harsh truth to investing, squandered opportunities cannot be made up for. They represent a permanent loss, just as a batter making the last out in a playoff game ends a season. There is nothing left to do but tip your hat to the other team and head off into the cold reality of winter. As we consider the market and economic backdrop, we may be entering a setup that represents an incredible opportunity for stocks. Consider for a moment what we experienced since 2021. We saw a generational inflationary pulse that spiked to nearly 10% as measured by CPI. The Federal Reserve in response raised short-term rates nearly 550% with Jay Powell explicitly stating that any collateral damage, even a recession, would be necessary evils in the fight against inflation. Despite all those headwinds, consider where we are two years later. A soft landing appears to be a reality, inflation sits at under 3%, unemployment remains well below 4.5%, and the S&P 500 has risen over 50%. The prediction business is tough. However, we would be fools not to take this opportunity to try to understand how we achieved this outcome. Just as a hitter studies film to build a gameplan for their next at bat, examining what got us here may provide some clues as to what pitch we may see next.

There appear to be some interesting dynamics underlying the economy that prevented a recession despite one of the most violent rate hike cycles that we have ever seen out of the Federal Reserve. These undercurrents are important to understand as they are overlooked by the financial media, yet their impact is undeniable given the unexpected outcomes we are experiencing. One aspect that we feel should be of particular focus, is a somewhat arcane piece of legislation that was passed all the way back in 2006.  Here we may find some clues as to why a recession has not been triggered up to this point, namely the Pension Protection Act.

Before diving in on that topic, let’s set the stage. It is a commonly held assumption (which happens to be true) that the stock market leads the economy. Given where we find ourselves today, it is useful to have a discussion as to why. What must first be understood is that US economic growth is dependent on credit. If credit expansion is occurring, then economic growth will follow. On the other hand, if credit is contracting you will almost certainly have a recession. If you don’t want to take this author’s word for it (fair), Richard Vague’s The Paradox of Debt is an excellent book on the subject. How does that relate to stocks? This next part is a bit oversimplified but what needs to be understood is that when markets are going up, we see earnings expectations go right up with them. Eventually, those companies arrive at the point where they can no longer outpace those expectations, and their earnings start to disappoint analysts. In a world where discretionary managers are evaluating those businesses and can sell, they do so as they arrive at the conclusion that it is time to harvest the gains that were made and identify more attractively priced investments. If markets have gotten far enough over their skis, we see markets broadly decline as other investors catch on and begin to look for exit liquidity. If this pattern maintains itself, we then enter a bear market as there isn’t enough sustained optimism for buying activity to reverse the momentum.

Where this becomes important is that when equities go down… so does the protection for the creditors of the underlying business. The equity is the buffer between the lender and an impaired loan on their balance sheet. For higher quality companies this tends not to be much of a problem as they have the assets to weather the storm, and creditors have plenty of collateral to protect themselves. On the other hand, for businesses that have more debt and not enough cash on hand to wait, this becomes existential. If creditors begin to think that the company may not be able to pay back the debt and have no equity buffer to protect them, things can go downhill fast. That is where you begin to see layoffs, bankruptcies, acquisitions at distressed valuations…and more layoffs. From there, you have unemployment shooting up which lowers overall aggregate demand in the economy, and voila… you have yourself a recession.

What on Earth does the Pension Protection Act of 2006 have to do with all of this? The legislation is important because it brought sweeping reforms to the defined contribution retirement system. In particular, it made Target Date Retirement funds the Qualified Default Investment Alternative (QDIA) in defined contribution plans. Prior to the act, cash was the default investment unless the participant selected another fund for ongoing contributions. Along with other reforms that incentivized plan sponsors to abandon active investment options in favor of passive, low-fee investments, unsurprisingly we have seen an absolute explosion in TDF AUM.

It cannot be overstated how dramatic that increase is, although Vanguard’s commentary below takes its best shot:

“TDFs have become the primary choice for a DC plan’s qualified default investment alternative (QDIA) since the passage of the Pension Protection Act of 2006. The percentage of plans using a TDF as their default fund grew from 71% in 2013 to 90% in 2022.¹ TDFs now account for 40% of all plan assets (compared to only 19% in 2013) and 63% of all contributions were directed to TDFs (compared to 34% in 2013).¹ Additionally, the space continues to grow regardless of the market environment. For example, despite the market volatility of 2022, TDFs saw more than $153 billion in new net cash flow.”

Jonathan Parker and his team at MIT have put together a brilliant paper on how this rapid and massive adoption is impacting single stock performance which you can find here.

More importantly, how did TDFs potentially prevent a recession? It is important to recognize that TDFs are perfectly price insensitive when they transact. Remember our discussion about how markets begin to go down once the underlying companies can no longer justify their valuations? That assumes a world in which the marginal dollar is going to active managers who focus on those characteristics. Passive strategists are completely indifferent to earnings forecasts, price targets, analyst reports, etc. When they get the flows, they simply buy…at whatever price the market offers them. As passive strategies are receiving over 100% of US equity flows (yes that statistic is right, your eyes are working just fine), the marginal buyer of stocks ignores all the signals that would cause a discretionary manager to sell. Don’t just accept it from this author, our friends at Pivotus Partners have been laser focused on this dynamic, see their note from September 20th:

We study nightly tax receipts because they are correlated to passive flows (both taxes and 401k contributions are set percentages of income).  There has been no discernible weakness in tax receipts so far.  In fact, Total Federal Tax Deposits have accelerated through September 18th (+8.9% cumulative Y/Y, versus +8.1% at the end of the second quarter).

Income withholdings are also proving to be steady at +6.1% cumulative Y/Y (basically the same level throughout all of Q3).

Data as of 09.20.2024

If the labor market is healthy, DC plans will continue to receive those increased flows which will be pushed into the market and be absolutely price insensitive. Now let’s combine that with a structurally tighter labor market that we have not seen in a couple of generations.

Data as of 10.04.2024

The point in all of this is that we’ve seen all the pitches, and everything is flashing that while we always need to maintain a proper hedge, the biggest risk is that investors don’t own enough stocks. Imagine being an investor in 1995 that was allocated to money market funds and bonds, waiting for a market crash that never came. If you wasted that opportunity in the late 90s, you had to wait for over a decade to get another chance at positioning yourself for a long-term run in stocks. It is no different than a hitter that keeps the bat on their shoulder when they finally get that one pitch in the zone. Once you let that moment pass, there is no getting it back.

In our view, investors should be approaching this moment with urgency.  Traditional stock and bond allocations are not going to reward you enough if our trajectory is to the upside. For the portfolio to be prudently allocated, the necessary excess exposure to bonds will likely be a drag on the portfolio return. On the other hand, if we were to see a recession crop up unexpectedly, the market has not even begun to price that scenario in and we’ve already discussed the spotty performance of bonds when things really get ugly. Our guiding principle of “More stocks, less bonds, risk-neutral” could not be more relevant given the current economic picture. Like Pete Alonso, we need to make sure that we are ready for our pitch.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2410-21.

The post Sitting Dead Red: Investing When The Count Is In Your Favor appeared first on Aptus Capital Advisors.

In early 2023, Cerulli Associates projected the AUM of direct indexing strategies to land at $800 billion in assets by 2026, from $446 billion in 2022. And 9 months into 2023, their data showed nearly $100b of that projection had occurred…the trend seems pretty robust.

Data as of December 2022

That would result in direct indexing representing 33% of the retail separate account market. One of the statistics that stood out to us was that Cerulli noted that 63% of advisors are currently serving clients with $500,000 or more in investible assets, and yet only 14% are aware of direct indexing or recommend it to their clients. Given those facts, we wanted to take the opportunity to write a quick primer on direct indexing. We’ll discuss where it works, where it doesn’t, and some things to consider when evaluating a direct indexing provider.

The good news is that the concept of direct indexing is straightforward. A provider will give you exposure to an index of your choice and use individual securities to best reflect that index. For instance, if you chose the S&P 500, a provider would typically choose around 130-150 stocks to replicate the performance of that index with as little tracking error (in English, get you as close to the same return) as possible. Why are people going to the trouble of doing all of this when you could just buy a single ETF and call it a day?

Well, if there is one thing investors hate more than losses, rate hikes, and fees…it is taxes. The beauty of direct indexing is that by using the individual positions to engage in “tax loss harvesting”, the objective is to create realized losses while also maintaining exposure to your chosen index. If markets are broadly moving up, stocks that aren’t performing can be sold with any realized gains being offset by the losses. In periods of market declines, any realized losses can be carried forward for future years which creates a “tax asset” while remaining invested.

Direct indexing can be helpful in several financial planning scenarios. In situations where a client is bringing in large amounts of highly appreciated stock positions, those stocks could be incorporated into a transition strategy where losses can be used to offset the realized gains from diversifying out of those positions.

In a year like 2022, those plans can be accelerated to reduce the concentration risk of the holdings and make an adverse market environment beneficial for the long-term positioning of the client’s portfolio. Perhaps an advisor is working with a client who has meaningfully increased their earned income and the client is now much more tax-sensitive.

A direct indexing strategy offers control over realized gains and losses that an active manager of an SMA or mutual fund strategy cannot provide. Bottom line, direct indexing has been an excellent innovation for investors who need to think about achieving their return objectives in as tax-efficient a manner as possible. Below is a helpful graphic from Cerulli that provides some insights on where sponsors see opportunities to apply the approach.

Data as of December 2022

With all of that in mind, no investment strategy is appropriate for everyone and in the case of direct indexing, there are situations where there is little benefit to utilizing the strategy. The most obvious example would be tax-deferred accounts where any distributions would be taxed at ordinary income rates. In those cases where index exposure is the goal, there is no need to complicate the portfolio with so many positions. Simply utilizing the most appropriate ETF to gain the sought-after exposure should be sufficient.

In conjunction with that, it should not be an automatic decision to put non-qualified assets in such a strategy either. While nobody relishes the idea of paying taxes, if the client is in a lower income bracket or their account balances are at a level where realized gains aren’t expected to be much of an issue, then employing this strategy needlessly complicates an investor’s portfolio. One of the tremendous benefits of index ETFs is that they provide instant diversification with just one position. The advantages of that simplicity should not be overlooked.

Another consideration for advisors and their clients is that there is no catch-all solution for mitigating taxes and gaining index exposure. One of the risks of tax loss harvesting is the tracking error that might arise from utilizing the strategy. As a simplified example, if stock ABC is sold for a small realized loss, it cannot be purchased for 30 days in any client accounts (even retirement accounts) as part of the wash sale rule. If that stock were to see a meaningful upside reversal during that period, that could result in tracking error to the benchmark and negatively impact the client’s return.

While tax loss harvesting can provide a way to reduce a client’s tax burden, there are limitations and risks to employing it that advisors should be aware of before making a recommendation. Elm Wealth has put together an excellent explanation of these risks in their paper “Direct Indexed Tax Loss Harvesting: Is the Juice Worth the Squeeze?” which is well worth the read. They argue that a more optimized solution would be to utilize ETFs as a solution to harvest losses while maintaining a purer exposure to the index. Our own Brian Jacobs here at Aptus has also put together a phenomenal piece on this topic: The Inherent Tax Efficiency of the ETF Structure.

With both the benefits and limitations of direct indexing outlined, we would like to offer a few considerations for advisors as they evaluate potential direct index providers. Direct index providers should be able to explain their process for harvesting losses while mitigating tracking errors. When the positions are sold, what securities does the provider use as a substitution to remain invested? What is the process for avoiding wash sales and can they provide a track record?

In cases where clients are bringing over-concentrated positions to be incorporated into a direct indexing sleeve, the provider should provide an estimated tracking error due to the position and an estimate of the realized gains needed to reduce the tracking error to the index. Clients and their advisors should be able to see the daily changes in the portfolio and be able to monitor what the realized gain/loss position is to avoid any surprises before filing.

Considering the incredible growth in direct indexing, familiarity with the strategy will likely become a core expectation of prospective high-net-worth clients. Bringing this all together, advisors who understand direct indexing and the tax benefits of employing such a strategy can set themselves apart from their peers. For many high-net-worth investors, tax planning is one of their core concerns, and advisors who can educate their clients on direct indexing and how that will fit into the broader financial plan will have a distinct advantage in earning and retaining those clients.

Understanding where the strategy works and where it will cause more problems than it is worth provides tremendous value, along with being able to evaluate which providers will be most appropriate given their client’s needs. While we would expect to see a continued healthy rate of adoption, the benefits and limitations need to be clearly understood.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2409-10.

The post Direct Indexing: A Few Considerations for Advisors appeared first on Aptus Capital Advisors.

Given this favorable backdrop, it might seem counterintuitive to think about portfolio hedging. In our view though, that makes this the perfect time to examine how your portfolio would perform in an environment where economic data and market returns are going in the other direction. Like how airlines do safety demonstrations before taking off, we want to think about the robustness of our portfolios and be prepared for an emergency while markets are calm.

The title of this piece addresses the most important question that you must consider when evaluating your hedges against those types of outcomes.

 Who is Going to Pay You When the Market is in Turmoil?

Readers of prior Aptus write-ups have often heard us say “More stocks, less bonds, risk neutral”, but for those new to us, this piece will explore why we express skepticism towards the conventional (likely consensus) belief that bonds alone offer sufficient protection for a portfolio. When markets are going haywire, funds are experiencing outflows, volatility is spiking, and cash is king, who is going to be there to pay you for those bonds?

In our view, excess exposure to bonds can impede your return during bull markets, while their performance during periods of upheaval will not compensate you enough for that return drag. Let’s examine the performance of corporate and municipal bonds during significant market drawdowns:

• The period following Lehman’s collapse (September ’08 – March ‘09)

• The sell-off following the failure of Third Avenue (December ‘15 – February ’16)

• The market selloff in Q4 2018 up to the “Powell Pivot” in January 2019

• The COVID crash (February 15 – March 24, 2020)

• The 2022 Bear Market

These instances show that bonds, commonly thought of as a “lifeboat” and considered safe havens, have been inconsistent on defense at best. In our view, the explanation is quite simple. If you want to monetize these positions (aka sell them to create cash), good luck finding someone to give you fair value when you need it most.

Lehman’s Collapse (September ’08 – March ‘09)

Third Avenue Failure (November ’15 – February ‘16)

Q4 2018

COV-19 Crash

2022 Bear Market

All Charts Source: Bloomberg as of 06.23.2024

Each of these five scenarios experienced a meaningful equity market drawdown and in none of these instances did we see both indices demonstrate a positive return. Common responses like “irrational markets”, “that was a black swan” or “who could have seen that coming?” often followed these periods, with most investors choosing to go back to what they were doing before.

In our view rather than outliers, these results make perfect sense if we consider the nature of bonds as financial assets. During crises, participants want cash, not assets. Managers facing net outflows must sell assets to pay redeeming shareholders. They sell what they can, not necessarily what they want to. Buyers, holding cash waiting for such opportunities, have no incentive to pay full par value for bonds, especially when they hold the negotiating leverage.

If you put yourself in the shoes of someone holding cash during any of these moments, what would you be doing? If you have cash you can deploy during these periods of market stress, you want a deal. After all, markets could always go down more, you expect to be compensated for taking on that risk. You are the gatekeeper for those looking to exit the market and hand off the risk of holding financial assets.

If your portfolio protection is only in the form of bonds, you are wagering that the gatekeepers will be incredibly kind to you during the exact moment that they have all the leverage. How likely does that sound? You may have no intention to sell yourself but remember, your portfolio is “marked to market”. That means that your portfolio value will go down due to the selling from everyone else who holds those same assets. Moreover, what if you wanted to buy more stocks to take advantage of the sell-off? Do you really want to be selling those bonds at a loss to create the cash to do so?

True Peace of Mind

Puts, on the other hand, function differently. They will go up in value when the asset they represent goes down. Importantly they offer a convex payout structure when that happens. Translating that statement into English, a helpful way to think about puts is the similarity they demonstrate to something like car insurance. You pay a certain amount in premiums, and should you get into an accident, your insurance will pay a lump sum to compensate you financially.

That is convexity in action, a nonlinear payout relative to the smaller premiums paid. There is a reason that they are called “options” to begin with. Should something unexpected happen in the market, you will have more choices because you have something that can potentially be converted to cash. You are holding protection that other market participants need and are incentivized to pay you for.

To wrap up, we do believe bonds have a place in a portfolio. They are less volatile than stocks and offer consistent cash flows over time. Our argument is against the conventional wisdom that bonds will with certainty protect a portfolio during periods of crisis. In fact, what the data shows is that bonds don’t offer the protection one might expect and can drag on long-term returns when markets perform well.

That is exactly why you hear us say “More stocks, less bonds, risk neutral.” It is not about taking on more risk, rather, it’s about creating portfolios that perform well in various environments and offer true protection during downturns. When you evaluate your own portfolio, ask yourself, who is going to pay you?

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2406-20.

The post Who is Going to Pay You? appeared first on Aptus Capital Advisors.