Still Just An ETF In A CAGE

On Monday, I sat in on a webinar for the Calamos Autocallable Income Fund (CAIE). We've spent some time here trying to understand the risks to the fund. We had a small breakthrough recently, the fund is exposed to equity risk not the typical risks associated with fixed income like credit or interest rate risk. 

One of the things we've been trying to figure out is what should be the expectation if the market goes down sort of a lot but doesn't come close to the barrier (the point at which distributions are suspended). I asked in webinar, I asked about a 20-25% drop in the reference index. To the webinar's credit, the answer was very direct. If the reference index fell that much, we should expect the fund to fall by the same or similar amount. The distributions should still flow but the price would drop. 

With covered call funds there is often talk that they will go down less than the market cap weighted equivalent and that happens sometimes.....not always, maybe not even half the time but it can happen. CAIE appears to have less chance of going down less. 

This is probably the only example to look at since CAIE listed in June of last year. 

Another fund in the Calamos Autocallable suite came up that I've heard of but we've never looked at. You can tell from the name that the Calamos Autocallable Growth ETF (CAGE) is different than CAIE, it is growth, not income. A simplistic explanation is that it reinvests the coupon payments back into the NAV instead of distributing them as income. 

It is leveraged exposure, CAIE is actually leveraged exposure too. CAGE appears to be doing what it is supposed to do. There are some serious complexities to this that I don't yet have dialed in. If the reference index drops a lot, I would expect CAGE to drop more. 

Below are the questions I came up with that I fed into Gemini to start learning about the fund. The answers are long winded of course so I shortened them up make for an easier blog post to read.

Roger: Does CAGE solve the issue of volatility drag versus a fund like SSO? I realize the leverage is different.

Gemini: Yes but it imposes a 6% annual "decrement drag," a hurdle that must be cleared before the fund starts to go up.

In the conversation, Gemini asked if I wanted to see a 20 year simulation. Here's that output. 

Simulation Highlights & Trigger Frequency

Data from the historical simulations shows exactly how frequently the internal ~29%–30% compounding coupons trigger: [1, 2]

• Coupon Trigger Rate: Out of 2,537 simulated weeks, the index successfully triggered an early autocall or coupon capture 1,984 times. [1]
• Probability of Capture: This yields a 78.2% historical probability that a note within the fund hit its positive performance target on an annual observation date. [1]
• Annualized Performance: Over a rolling 10-year simulation window, the underlying index achieved a 23.75% annualized return, noticeably outpacing the standard S&P 500 total return index over the same backtested period. [1, 2]
• Capture Ratios vs SPY: The index recorded an upside capture ratio of 1.06 and a downside capture ratio of 0.86. It captured more market upside while blunting a portion of major drops. [1]

This color was important;

Summary of the Catch

The 23.75% simulated return looks highly attractive, but it is a byproduct of a 35% constant volatility target. During quiet, flat, or slowly grinding bull markets, the index uses internal swap leverage (up to 500% gross exposure to S&P 500 futures) to manufacture that 35% volatility. This synthetic leverage is what allows it to generate massive 30% coupons even when the actual S&P 500 is only up 2% or 3%. [1, 2, 3, 4, 5]

The risk is that in an extended, multi-year flat market, the 6% annual decrement drag will continually erode the index baseline, making it progressively harder for the oldest notes in the ladder to trigger. [1]

Roger: In a repeat of 2000-2009 inclusive, should the fund be expected to do worse than simple market cap weighted S&P 500?

Gemini: Yes, CAGE would be expected to perform significantly worse than a simple market-cap-weighted S&P 500 during a repeat of the 2000–2009 "Lost Decade."

Roger: Is the 6% hurdle how JP Morgan gets paid?

Gemini: Not exactly, more like how it can pay out the huge "coupons" that get reinvested (simplistic term for the circumstance).

Roger: Would it make sense to buy the fund after a large decline in markets and all those problems start happening?

Gemini: Yes.

Roger: SSO tends to track 2x the S&P 500 closely over longer periods. Again, just a tendency. CAGE seems like it would have greater variation in how it tracks the S&P 500. Is that correct?

Gemini: Yes

This next point is very important.

The Dynamic Leverage Shifts (35% Vol Target)

• SSO maintains a rigid 200% exposure to the S&P 500 every single day, regardless of whether the market is calm or chaotic.
• CAGE dynamically adjusts its leverage to maintain a constant 35% implied volatility target.
  • In a quiet market (low VIX): CAGE must heavily lever up (sometimes up to 400% or 500% gross exposure) to manufacture that 35% volatility.
  • In a wild market (high VIX): CAGE must drastically de-lever to keep its internal volatility from spiking past 35%.
    This means CAGE's effective beta is constantly morphing based on market fear, causing huge tracking variations over time.

Not because it is easy to understand, it isn't, but it speaks to the complexity of the fund. I later asked if it is constantly adjusting the leverage and the answer was yes. That also applies to CAIE, it is constantly managing the leverage to dial in the correct volatility target. This could lead to a whipsaw of sorts although that hasn't happened up to this point. 

Roger: Could CAGE be thought of a way to allocate to asymmetry but without diversifying the risk away from market cap weighting?

Gemini: Yes (it liked that framing).

Hoo boy, that is a doozy of an introduction. I tried to make this a simplistic introduction not technical paper. Please leave a comment if you dig in and find things I missed in this first look. 

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.