A Use Case For The Unusable?

A frequent point we make is about certain fixed income exposures having equity-like volatility and comparing what they look like versus alternatives that behave the way investors hope fixed income will behave. 

Based on the opening paragraph, you can probably guess which line tracks the traditional fixed income bond fund. Two of the other four lines are alternative fixed income products and the other two are not fixed income strategies but they behave in the way I believe investors hope fixed income will. 

The primary attribute that we're seeking a reliable offset to equity volatility. A couple of the charted funds provide pretty good yield and the other two have no yield. While the one traditional bond ETF was down 25% in 2022, the other four ranged from a decline of 2.51% to a gain of 2.54%. Tell me if I am wrong, but I can't imagine the typical investor would want a fixed income exposure with that kind of volatility, prone to that type of decline. 

The four funds all do very different things and while the correlations among the group aren't that low, there is differentiation of risk factors despite how similar the charts are for the four. 

The prompt for this post was a writeup at AQR bagging on defined outcome/buffer funds. One of the four charted above is a defined outcome fund. The whole defined outcome/buffer space has evolved in many directions offering a lot of different strategies, really a lot and it is not a rabbit hole I intend to go down. The TLDR for the AQR piece is it makes more sense to just lower your equity percentage, putting the excess into T-bills, than to use the typical defined outcome/buffer fund and I agree. The earliest versions of these limit the upside with unlimited downside minus the first X%. Again, limited upside, unlimited downside. It doesn't make sense to me.

Corey Hoffstein Tweeted out a link to the piece too and is negative on these. A follower of his asked about using them as fixed income substitutes. Some of the variations are marketed this way and Corey replied that he's never seen anyone do this. So from here, forget about them as equity holdings, can any of them behave like fixed income? And if they can, should anyone use them in that manner?

One of the bigger funds in the space is the Innovator Defined Wealth Shield (BALT) not to be confused with BTAL which is a client and personal holding that I write about all the time. Where some of the defined outcome/buffer ETFs have a maturity date, BALT is perpetual, it resets every 90 days. BALT is one of the four funds charted in the above backtest. It appears to quack like a bond substitute. For the current period which ends on 3/31, the upside looks like it was capped (limited) at 2.41%. The downside, the buffer, protected the first 20% down  after which shareholders would ride it all the way down for the remainder of the quarter. Dropping more than 20% in a quarter doesn't happen often but it has happened.

Here's the current dip.

As far as the chart showing a 1.6% decline for BALT, that is from the start of the dip, not the three month period. YTD it shows down 0.2%, so it went up a little for the first six or seven weeks of the year, down very little from the peak and the YTD number could be as simple as the last trade hitting the bid. 

Is anyone using BALT as a fixed income substitute? I don't know but the AUM is over $1 billion so it is being used for something. BALT has never paid out a distribution so it is tax efficient. It's not going to go up if stocks drop, if it will help at all, it would be as a horizontal line that tilts upward. 

The constituency of the fund is that it holds a four legged option combo. It is long and short both calls and puts but in a way that is different than a box spread. If in some random future quarter, two months in or whatever, the S&P 500 was down 18 or 19%, a holder could just sell it if they were concerned that event was going to spill into a 30 or 40% decline. Beyond a 20% decline for the index, it should be expected to drop inline with the market. Again, I mean after that first 20%. If a 40% decline were very slow though, over the course of the year and assuming no malfunction, it could ride that out with no meaningful loss beyond a few basis points. 

As I sit here now, I don't ever see using this for clients but where I did nothing before but crap all over them, there is a use case once you understand the flaw, declines larger than 20% in a short period, and understanding this shouldn't be expected to look like equities when stocks go up by a decent amount, not even a lot, but a decent amount. 

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