XYLD - Portfolio Construction Options And Covered Call ETF Vulnerability

2023-11-21 13:15:00 ET

Summary

• How should investors construct their portfolios?
• Rob Isbitts recommends playing offense and defense in the market.
• Covered call ETFs like JEPI may be overrated and vulnerable in a worsening market due to their limited upside potential and potential for significant losses.

Listen above or on the go via Apple Podcasts or Spotify .

How should investors construct their portfolios? Rob Isbitts on playing offense and defense in the market (0:47). Treasuries, T-bills and portfolio staples (7:30). Issues with covered call ETFs (17:30).

Transcript

Rena Sherbill: Rob Isbitts, welcome back to Investing Experts. It's great to have you back on the show.

Rob Isbitts: Thank you, Rena. Great to be here. And boy, there's plenty going on and plenty to talk about. So, ready to get right into it.

RS: It seems the world is never short of giving us things to talk about. Likewise, the markets, I would say. So, we've been talking on this podcast this week a lot about economic data and what the macro picture looks like. It's pretty much smack dab in the middle of November. How are you thinking and looking about the markets?

RI: Sure. So my go-to is this piece of proprietary intellectual property I created called the ROAR Score, Reward Opportunity And Risk. And it really is just as simple as how much offense and how much defense do you want to play, or take proverbial $100, how much of that $100 would be playing offense, which is typically equities, and how much would we be playing defense.

And defense for a long time was inverse ETFs, because of course I'm an ETF geek, but with the rise in T-bill rates after 11 Fed rate hikes, those have become very viable and even some of the medium to long-term bonds as well for defense.

The ROAR Score, so 100 is absolutely the most bullish, low risk, and zero would be like, maximum risk of major loss. So, it's like a floating allocation. It's been below 50 since August 10th of 2022. It was sitting at 10 for almost a record, 8 weeks or 9 weeks in a row, and it now sits at 25.

So I think that some of the pressure is off - and I'll talk about this in a few minutes regarding how you can look at the fact that a lot of stocks have not participated, not just in the very recent rally the last week or so, but over the last few years.

But I think it's interesting if you want to kind of sum up where the stock market is, look at where it's been. The S&P since August 10th of 2022, when that ROAR score of mine went below 50 signaling sort of tilting toward defense. Okay. I don't use terms like bull and bear market, but the S&P was at 4,200 back then. It fell to 3,600. It went to 45 and change. It dropped to 4,100, and now it's at 4,500. So it's been in a trading range for quite some time.

And that's just the S&P, which really has not told the story of the broader market. Stocks have been trading in a range or persistent lower lows. The technician in me sees this sort of gradually stepping down. The highs are lower than the previous high. The low is lower than the previous low, it looks like you're walking down stairs. And that has been the story for so many stocks, not since just 2022, but since 2021 or even 2020 in some cases. So, that's equities.

And for bonds, the case, I think, is a matter of, hey, not so fast. T-bills below, really one-year and below, are still well into the 5% range. And there's a lot of great implications for building portfolios with that as a base. And that is where most of my personal assets are frankly. But as the year has gone on, the higher yields have kind of bled out into 2, 3, 4, maybe even 5-year treasuries where you can still get close to 5%.

The biggest issue right now, and I've written about this and lots of people have , but this obsession with an ETF whose symbol is ( TLT ), which covers the 20-year to 30-year treasury, which is not really a logical investment for most people, but it has become an obsession with people trying to pick the bottom because TLT, long-term treasuries, remember, these are bonds. These are treasury bonds we're talking about, down at one-point a few weeks ago, 46% from its high.

This tells me that there's a lot of trading ranges out there. I would say people should enjoy the end of the year festivities, however they celebrate, but don't you dare take your eye off the prize when it comes to markets and portfolio, because even a continuation of this recent stock market rally and plunge in long-term yields - I could see the possibility that that can happen for a little while, but the dangers that existed a few months ago are still very much on the table.

RS: So, how would you advise investors to look at it? How do you think they should be allocating their funds?

RI: Well, that's a really good question because I just wrote an article for Seeking Alpha back on October 27th. And I think the headline talked about my options portfolio, but I basically said, here is exactly how I'm invested strategically across all the different types of accounts.

I think there's two things that I can say. I'm going to explain a bit of my process and as they say, don't just say it, show it. I have different buckets of assets, which I describe fairly clearly in that October 27th piece for Seeking Alpha. And it goes something like this.

When you can lock in a return out a year, almost 2 years of close to 5% or more, that – unless you're a very aggressive investor and I'm not, I'm kind of in semi-retirement mode. I want that to be the anchor of my portfolio as long as those rates stay up, and I'll extend the maturities out just long enough to when I think that the equity market, the long-term growth engine and the dividend producer for investors, when that is at a point of greater clarity, when my ROAR Score is above 50, not straddling between 10 and 25.

So, specifically, the staples of my portfolio, really, I mean, since probably this time last year, maybe sooner, are ETFs. I mean, I own T-bills directly also, but ETFs like a symbol ( SHV ) or ( BIL ), which cover different parts of the treasury curve. I own a decent position in 2-year treasuries directly, but I also own ( UTWO ), no relation to the classic rock band, ha-ha, I will follow that one as long as the yields are reasonable.

And the other thing is, you can go out just a few years in treasuries. And if rates plunge, as people are starting to say, “Okay, well, eventually the Fed's going to have to lower rates.” Well, maybe they will, maybe they won't. And bonds are not bonds.

Okay, there's different parts to it. I would say there's the short-term part of the curve. There's the very long-term part of the curve, which you might as well be investing in equities for the volatility we've seen in TLT, et cetera. And then there's the middle part, which hasn't really developed a modern market's personality yet because the yields were suppressed for so long.

So, the ETFs I mentioned, kind of give me that ballast at the base of the portfolio, because think about it this way. If you have about 70%, 60%, 80%, somewhere in there, in something where you pretty much know lock, stock, and barrel, as long as the government can still pay you, and if they can't, then we all have bigger problems.

Then you've locked in a minimum return. I mean, you know, right? If we just do the math, if 60% of your money is earning 5% for the next 2 years, that's a 3% return. The other 40% could lose 7.5% and you've broken even in a down market.

So, to me, that combination of take the free gift, so to speak, and then try to use the other part of the portfolio. And unfortunately, I just don't see a lot of buy and holds out there. I see a lot of tactical moves. And again, mostly the prism for me is ETFs. So I have owned things recently , such as the Blockchain ETF, ( BLOK ).

But here's a perfect example. I own it. It's up 5%. I've owned it for 2 weeks. I'm not cherry picking here. I'm giving it as an example. Well, if it turns out like a lot of tactical moves, it might not go up much more. And at some point, I'll have to say, okay, I wish I could have owned this for a year longer, and I can't. I have to drop it because it goes up 7%, 8% and then drops 20%.

This is that lower lows and lower highs. So I think investors understanding that we are in a macro market environment where the risk to the downside is still so high. Again, ROAR score at 25, not at 50 or 60 or 70. There is risk of major loss.

With that said, there are things starting to set up that I'm at least, I don't want to use hopeful because hope is not a strategy, but I would say I have optimism that we may finally see some things that have legs where you can be more than an equity investor that holds for weeks or even days that you can hold for years. And I can talk about where some of those would be.

RS: Yeah, for sure. What are those points of optimism that you're looking at that you hope set up?

RI: The simple way to go about it, but I think it's oversimplified and I see retail investors especially do this all the time. Time will tell whether they're doing it with TLT.

The basic investment lesson that I want to get across to folks is that just because something is way down in price, it doesn't mean it's investment cheap. If that were the case, then you could have bought TLT when it was 10%, 20% down because that doesn't happen very often.

And then you just keep going. And of course, I think we both know the math, right? How many times can you lose 40% on an investment? Some people would say, well, they lose 40 and then you lose 40. And then after that, there's only 20 left. No, no, no. The way the math works, you could lose 40% of whatever is left every time.

And this is why I suggest that all investors, all serious investors go back and study up a little bit on the dot com bubble era, because one of my most bullish cases for the broad equity market - technology probably looks as strong as anything right now. I mean, duh, it's pretty easy to see that.

But, you know, my charting work, and, you know, I'm a technician for 43 years. So, my chart work says, you know, this has at least the potential for temporary liftoff. So, you could see the ( QQQ ).

I play it in more sheepish ways. I own ( XLG ), which is the top 50 stocks in the S&P 500. So, it's more tech exposure than ( SPY ) or ( IVV ) or ( VOO ), the three big S&P 500 capitalization weighted ETFs. So I own XLG, it's the top 50, but it's heavy in technology compared to the S&P 500, but not nearly as much as the Nasdaq.

So I can see at least, because again all we're doing here - investing is not about right or wrong. It's not about, it's going up and I'm 100% sure. That's why, again, I have the ROAR Score. 25 out of a 100 kind of means that the confidence level that equity moves are going to last is still quite low.

But with that said, one scenario and the reason I own XLG, in decent size, I mean, it's the biggest equity position I have. I also own ( DIA ), which is the Dow, because I look at the 30 Dow stocks, not just technically, but looking at Quant Ratings on Seeking Alpha and just knowing those 30 companies, they look better than the market on average.

So you put all this together and say, okay, maybe it's the beginning of a new bull market. Not so sure about that. What I think would be a more likely outcome if the market continues to go up is that it goes up like a rocket ship because you have all these professional money managers that have been caught off sides since the beginning of the year, have been under invested in a year where the NASDAQ is up like 40%.

And they, whether they want to chase it or not, they probably feel like they need to, or they're going to get fired in January or February if their clients even wait that long. This is an issue for advisors. This is an issue for hedge fund managers. And frankly, it's an issue for investors because they shouldn't make everything a one-year contest but that's another story for another day.

So, you know, that rocket ship. Okay. I mean, I don't think it's out of the question that you could see the NASDAQ go significantly higher in the end of the year and maybe even at the beginning of last year. Why? Because there is historical precedent in the dot com bubble era, the strongest returns in upswings like that happen at the very end, and then they crescendo, and then they fall from Earth.

And you don't have to look back any further than a few weeks ago to see that all this money was flying into the ( TLT ) ETF. That ETF more than doubled its assets over the last 3 years. At the same time, it was being cut practically in half. If you do the math on that, think about how much money has been lost in TLT.

If the assets have doubled at the time when the actual share price has been cut in half, okay? That's some historic math right there. And toward the end of the TLT decline, it got sharper and sharper and sharper, like people were just throwing it out of their portfolios.

Talking about TLT and I'm talking about ( XLG ), but these are, if you will metaphors for the type of market that we are in where there's a wide range of things that can happen. And so, I would rather pound into my portfolio a lot of things that I know what I'm going to get, at least for the next year, while so much of this turmoil plays out.

I can always lighten it up later when the coast is a bit more clear, but picking bottoms in markets like this, with all the algorithmic traders swinging things around, you know, good luck to anybody who can do it. That's not me.

RS: Last time you were on, we were talking about covered call ETFs , where you were recalling option infused ETFs. How does that come into play when you're talking about how you're using these ETFs?

RI: Here's the thing with the covered call ETFs. And again, just like when people say, oh, are bonds a good buy? Well, I think T-bills have been a great buy for a very long time now. But long-term bonds, long-term bonds have been absolutely a portfolio destroyer and maybe now they're a source of big returns. But when you say bonds, there's a lot of different things.

I'm going to be doing a lot more writing I think about bonds because I think that there's a gap broadly in investor understanding. And it's understandable because it's been 15 years since anybody had a care about bonds because they weren't yielding anything.

So, you know, when it comes to covered call ETFs, I recently had a little bit of a journey with those. I mean, I've used them for a long time. I mean, I used to run those types of strategies within a mutual fund that I ran years ago. It was kind of a hedge mutual fund. So, I've been a practitioner for a long time and I saw all these other products come along.

You know, ( JEPI ) being the one that I referred to as, I don't think it's a bad investment. I just think it's overrated because I just don't think that it should have had $28 billion, $29 billion, $30 billion or whatever it grew to over a few years. It's solid, but overrated. And I can say the same thing about a lot of ETFs that are very popular, not just – not picking on that one.

But here's what, you know – you invest in something, you dabble in it. I started to get a little bit more serious. I do own several covered call ETFs. I don't own JEPI. I own ( XYLD ), which is the Global X product that covers S&P 500. I own ( QYLD ), which covers the Nasdaq, and I own ( TLTW ), which is that TLT but with covered call writing. You can imagine the income that comes in from that with all the volatility.

But here's the issue with covered call writing ETFs. There are times where they are excellent investments, but through no fault or control of the investor, they can become dead money investments. And again, if something has very, very, very low upside potential and massive downside potential, can we agree that that is something that you probably don't run after as an investor?

RS: Unless you're running a masochist fund.

RI: That's right. That's right. So, here's what happened recently, okay. I saw a buying opportunity in some of these, okay. I'll use XYLD as an example because it's the basic one, okay. It's the S&P 500. It's entirely covered by calls, okay. Now, JEPI and some of the others, I think they have one advantage over some of these others in that they don't cover the whole portfolio, okay. And there are many others. So, when people say, oh, covered call ETF, don't overgeneralize and say they all work the same because they don't.

So, but let's look for the ones where they say, okay, we buy the S&P 500 and we completely cover it with options. That basically means that every month you're going to get an income payment based on the volatility of the S&P 500. And I don't know, maybe that amounts to high-single-digits, low-double-digits. You might get a little bit of upside, but not much, because the whole portfolio is basically capped at where those covered call options are struck.

So, here's what I saw recently in the covered call world, and it almost makes me think that they will ultimately be seen as better tactical vehicles than long-term vehicles. So, here's what I saw. So, the S&P falls just about 10%. I look up on the website for an S&P fully covered call ETF and I say, look at that. Okay, I'm using my options experience.

So the strike price of the options that are covering the whole portfolio is up at like, I don't know, let's pick a number, 4,500 when the S&P is at 4,100. So, what does that mean? That means that you're still going to get that dividend every month, but you have upside because those calls don't stop your profits until S&P goes from 4,100 to 4,500.

Well, that probably won't happen so quickly because it could take a little while to get back to that. No, wham. In like, I don't know, it seemed like two days, maybe it was two weeks. The S&P goes from 4,100 to 4,500. So that was nice return for ETF like XYLD and some like it. But now what? Now, you're basically dead money at $4,500 until the next month when they'll give you a little bit more income. So, to sum this all up, you're getting income in these things little bits at a time once a month.

Let's say you're getting, I don't know, three-quarter of a percent, maybe 1% a month. But you can also, if the market goes down in weeks, not months, you can lose a year's worth of that income very quickly. In this case, it snapped right back. Great. Just keep earning your income.

Pretend the last couple of months didn't even happen. But in a worsening market, if this down ladder, lower lows, lower highs continues, then I think a lot of covered call ETFs that are fully covered and less so, but still a case for the partially covered, they are vulnerable because it's like you're bringing in money, even if you're bringing in 1% a month, if the market falls 10% or 20% in the next 6 months, you can't make up for that in income. And last I checked, losing money is worse than preserving capital.

RS: Could you synthesize – I appreciate that rundown. Can you synthesize, I feel like it would be who investors listening to this, why JEPI was so popular and why you call it overrated?

RI: Sure. Yeah, I wrote about this a little bit. And as I see it, well, okay, so the biggest reason that I had some concerns about JEPI and my concerns were so great that I actually called JPMorgan who runs it and I asked some questions. I wasn't like some private investigator, but I looked at the prospectus.

I looked at the current holdings, I was able to figure out, okay, I see the stock portfolio. That's the great thing about ETFs. You can see the stock portfolio every day. You don't have to wait like every month or 3 months like in mutual funds. You know what you own inside of there every day.

But in the case of JEPI, the way they go about the covered call writing is through private investment vehicles. So, if you go to the Global X website, you can see exactly what they own. It will say we own this many contracts of ( SPX ), the option symbol, this strike price, this expiration date, and this is how many days we have till expiration. And then one day before the end of it, they swap out that one and they go to the next month. And this is what they do.

In the case of JEPI, it's, I think a little bit more like, hey, trust us, we know what we're doing. Now, maybe that's because the fund is big. And I think they're starting to release a little bit more information about it, since I first sort of challenged it. Certainly not because I challenged it. But you look and it's like, okay, so I want to know because remember that analysis I just did, you can't do that with JEPI if they don't tell you where the options are struck, how far they go out, okay?

And so you can't analyze it the way you would if you were doing it yourself. And to me, one part about ETF investing is the convenience and the discipline of having an index or an active manager do that for you. So that really had me miffed. I mean, I was like, really? Like you can't. And maybe it's because the fund just got so big that they had to do it all private. Fine. But the fact is, you, me, investors in any fund, if you don't know what you own, I say, hey, it's doing okay, but it's overrated to me because there's a transparency issue.

RS: Anybody with questions about ETFs or portfolio construction, keep your questions coming and we'll hit them up with these conversations with Rob. So, let us know what you think. Rob, appreciate you coming on. Look forward to the next time. Get your ETF questions in everybody.

Anything else you want to leave listeners with before we go?

RI: All I would say, and I think I say it every time, but I'm going to say it especially now, given the state of the world and everything. I think you're awesome and you're awesome at what you do and so is Seeking Alpha. It's an incredible community and I would just love to continue to raise the bar within that community as one of many people that have kind of, you know, been around the block in this industry.

RS: Yeah, amen. I hope to raise the bar too on the shoulders of giants. May we all continue to raise the bar. Appreciate it, Rob. Great conversation. Thank you again.

RI: Thank you, Rena.

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