Autocallable Theory

Larry Swedroe did a deep dive on the Calamos US Equity Autocallable Income ETF (CAIE). The basic idea with the fund is that it owns a series of structured notes that mature each week. The fund targets a 14% distribution. The fund would run into serious problems if it's reference index fell 40%. The reference index is similar to the S&P 500. CAIE has sensitivity to the reference index on the way down but in its one test so far, it captured a lot less of the reference index' recovery which is to be expected based on the structure of autocallables. 

You might look at that and decide right away these aren't for you (XV, SBAR and ACYN are also autocallable funds) but there has been no malfunction with them. 

Some points made by Swedroe; first is that 90% of the distribution is a return of capital. Yes it is a very high percentage. He warns that this has the effect of lowering your cost basis in a taxable account so that when/if you sell the cost basis might be nothing, so you'd owe a capital gains tax. Yes but that would be less than the tax on a true dividend. 

Larry then talks about gains being capped as I noted above which is correct. Don't buy this looking for an equity proxy on the upside. Larry notes the 40% threshold for problems starting, that is called a barrier, and yes a decline that big would be bad for the fund but it would be bad for everything. Don't buy this looking for downside protection. He further equates it to being short a put option which gives some good context for how it should behave.

The next issue is the counter party risk with JP Morgan and the cost embedded to pay the counter party. This isn't quite the threat he makes it out to be, if you don't already know this, don't bet too much of your portfolio on the credit worthiness of one bank. The odds of things ending badly for JP Morgan are quite low but sized correctly the actual risk is minimal.

He picks at the complexity and opacity. Yes, they are both, moreso complex than opaque. The strategy is learnable, I'd argue that these funds are less complex than the typical macro fund. Yes it is not cheap too. This is not a three basis point index fund. 

Larry says the NAV must erode and you can see that with SBAR and XV but it hasn't happened yet with CAIE. It probably will erode but I am always leery of using the word must. 

The article finished with checklist of sorts, what you want versus what you get. Once you understand what the fund does you realize that if you want what Larry says you want, you should find a different strategy.

As a matter of curiosity, I'm always going to want to try to find a plausible use for these flawed products, products riddled with drawbacks anyway. I continue to believe there is a use case for things like autocallables and crazy high yielders as part of bridge to the next financial milestone like taking Social Security or taking RMDs with the expectation that any basket of these will deplete toward zero.

The question/tradeoff goes something like this. An investor is 62 and wants to live off a $200,000 bucket of money until they take SS at their preferred age of 68. The income need from this piece of money is $40,000/yr for six years. If they leave the $200,000 in cash they can get five years, plus a couple of months from the interest. How likely would it be to squeeze out a sixth year or even a 7th thanks to the large distributions (ROC and all).

Using a combo of autocallables, not the craziest high yielding YieldMax funds (think Microsoft and Google, not Tesla and Microstrategy), cat bonds, then a sleeve in something like the BCKT or LDDR ETF which both offer depletion strategies and I threw in WTPI which is a pretty high, not crazy high, yielding  ETF that sells put options and doesn't really erode, it doesn't go up on a price basis but it hasn't eroded. There are countless closed end funds that could be part of the discussion to. 

With enough holdings, like maybe a dozen, any sort of issuer risk, strategy risk or idiosyncratic risk could be reasonably diversified.

Back to our $200,000 example, taking $40,000/yr from a basket of these would leave $57,000 left over after six years and probably get the investor through a 7th year with just a little leftover.

If it works out that a lot or most of the "yield" is ROC, that would not count toward modified adjusted income which could keep someone below the income threshold for health insurance from the marketplace to be subsidized which would be helpful until Medicare starts.

There are several grains of salt to take here related to reduced distributions and an extended downturn in markets but to the extent we do some work here on portfolio theory, this one is pretty far out there but still interesting. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.