Episode #402: Paul Kim, Simplify Asset Management – Embracing Convexity Through The ETF Structure
Guest: Paul Kim is CEO and co-founder of Simplify Asset Management and President of Simplify ETFs, a new ETF provider focused on helping advisors build better portfolios. Previously he was head of ETF strategy at Principal, building out a family of smart beta and active ETFs.
Date Recorded: 3/8/2022 | Run-Time: 54:59
Summary: In today’s episode, Paul kicks it off by giving us an overview of Simplify and the firm’s focus on long volatility ETFs that either generate income or hedge downside risk. We touch the ability to use options in the ETF structure, an idea Paul and his team have embraced to create convex strategies. After looking back at Paul’s time at Pimco, we dive into some of his strategies. We touch on strategies that hedge bonds and stocks and even Simplify’s thematic health care ETF that gives 100% of the proceeds to charity.
Sponsor: If you’re seeking the less obvious and are curious about the ever-changing world and how it affects investing, The Active Share podcast is for you. Hear thought-provoking conversations with thought leaders, company executives, and William Blair Investment Management’s own analysts and portfolio managers as they share unique perspectives on investing in a world that’s always evolving. Listen to The Active Share on Apple Podcasts, Google Podcasts, Stitcher, Spotify or TuneIn or visit here.
Comments or suggestions? Interested in sponsoring an episode? Email us Feedback@TheMebFaberShow.com
Links from the Episode:
- 0:40 – Sponsor: The Active Share Podcast
- 1:15 – Intro
- 1:57 – Welcome to our guest, Paul Kim
- 2:41 – Overview of Simplify
- 6:15 – Paul’s start at Pimco
- 11:01 – Why the ‘derivatives rule’ was a game changer for ETFs
- 14:42 – Simplify’s early strategies and concepts
- 21:23 – Overview of Simplify’s interest rate strategy
- 27:51 – How Simplify comes up with their strategies
- 29:56 – The high yield credit hedge and CDX ETF
- 34:20 – What advisors are concerned about
- 36:40 – Simplify’s strategy that uses GBTC
- 45:43 – Paul’s thoughts on building out Simplify going
- 51:30 – Paul’s most memorable investment over his career
- 52:15 – Learn more about Paul; simplify.us
Transcript of Episode 402:
Welcome Message: Welcome to “The Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Sponsor Message: What does a two-time World Cup-winning coach, a Major League Baseball team owner, a top chef and a luxury fashion designer have in common? They’ve all been featured on “The Active Share Podcast.” If you’re seeking the less obvious and are curious about the ever-changing world and how it affects investing, “The Active Share Podcast” is for you. Hear thought-provoking conversations with thought leaders, company executives, and William Blair Investment Management, own analysts and portfolio managers as they share unique perspectives on investing in a world that’s always evolving. Download “The Active Share Podcast” on iTunes, Spotify, Google, Stitcher, and TuneIn.
Meb: What’s up, everybody? We got a fun show today. Our guest is Paul Kim, co-founder and CEO of Simplify Asset Management, ETF provider focused on helping advisors build better portfolios. In today’s show, Paul kicks it off by giving us overview of Simplify and the firm’s focus on long volatility ETFs that either generate income or hedge downside risk. We touch on the ability to use options in the ETF structure, an idea of Paul and his team have embraced to create comeback strategies. After looking back at Paul’s time at PIMCO, we dive into some of his strategies. We touch on ones that hedge bonds and stocks, and even Simplify’s thematic healthcare ETF that gives all the proceeds to charity. Please enjoy this episode with Simplify’s Paul Kim.
Meb: Paul, welcome to the show.
Paul: Hey, Meb. Thank you. Great seeing you again. Thank you for having me.
Meb: Yeah, man. Where do we find you today?
Paul: I’m in Westchester. Sun’s peeking out. We’ve had a very miserable long winter and I’m hopeful things turn around soon.
Meb: What is that? A cello in the background?
Paul: Yeah, started when I was in the fourth grade. Now, it’s mostly there for my daughter, but I try to play once in a while.
Meb: Good. We need some new intro music for the show. Enough of this…I don’t even know what we call what we have.
Paul: The cello might put you to sleep.
Meb: Yeah. Last time I saw you, we were pretty high elevation hanging out in Telluride, Colorado, and not a lot’s happened since then.
Paul: Feels like a decade ago.
Meb: I know, right? Looking forward to the world settling down post-pandemic, quiet times, but here we are. So we’re going to talk about all sorts of stuff today. ETFs, the markets, everything that’s going on in the world. Tell us a little bit about Simplify, a relatively new entrant in our world.
Paul: Sure. Like your shop, we’re an indie or a relatively new ETF provider, just got started. First ETFs came to the market in September of last year. We’re at a crazy number of ETFs now, 22 ETFs, right about $1.2 billion. And I think our focus really has been what’s often called a long volatility market. We’re generally trying to be long options, long complexity, long asymmetric risk, and mostly in the form of things that hopefully either enhance returns or income, or mostly hedge downside risk.
Meb: Recording this early March where nickel’s gone bananas and all sorts of other commodities too. Shortfall to me is always a really dark, scary place if left alone. So long vol seems to be where my personality gravitates a bit. But you did mention you came out guns a-blazing. Of all these funds you have out, you mentioned long fall, but are there any just general themes, categories, framework for how you think about the world? And how many guys going to churn out my man? Are you going to be 30, 40, 100, 200?
Paul: Unlikely. I think we’re rushing to try to get most of the investment asset classes covered. Mostly, your main buckets of equities, a couple of key fixed income exposures, and then growing but small pool of alternative strategies. And the goal was always to fill out a model. And I think ultimately, that’s where a lot of people look for ETFs to fit inside of portfolios. And so it was always a portfolio framework and we were just rushing to get some of these out so we could have a complete set to go market and create models for.
That’s really the pace of it, but I think the number one category we have is basically your portfolio asset allocation building blocks. Think of your U.S. large caps or international develop, etc. And all we’re doing is overlaying a little bit of options on top. And what that’s doing is instead of having to go to an options overlay manager and try to wrap an entire portfolio, we’re trying to put it inside of ETF where you have the convenience, you don’t have to worry about paperwork. You have a captive product that has a self-hedging aspect.
And then increasingly, it’s becoming very tax-efficient to put options inside of ETFs. And so I think that’s really sort of disaggregating and then re-aggregating the values of options inside of a portfolio. That’s our main lineup. And then we have some innovative ideas around really democratizing hedge fund-type exposure. So think of your tail risk strategy in a different form, a true out of the money, really once every 5 to 10-year type payoff, tail risk strategies, highly convex, put it inside of an ETF and don’t require a big check or 2 and 20, put it inside and democratize it. And I think you’ve done a lot of work in that world as well. And so I think the more choices that investors have to bring interesting exposures and protection into the portfolio, the better. And the more providers provide their take, I think it’s better for their environment as well.
Meb: There’s a big argument in your favor on the launching the funds. If you do a regression of ETF company assets versus number of funds, there’s a pretty strong correlation now. There’s a little bit of bias baked in there, which is the ones that launched a lot of funds.
Paul: Survivorship.
Meb: Right. And gone out of business.
Paul: If your first couple stink, you don’t get to launch anymore.
Meb: That’s right. But as a quant, I’ll just ignore that backtest and say, “Look, see, here we are.” I want to do some deep dives on some of these strategies here in a minute, but thought we’d talk about your on-ramp for a second. And this sort of optimistic, bold, naive decision to launch ETF company and go up against the likes of BlackRock and Vanguard, the death stars of our universe with trillions in assets. You started out at another big shop, right? PIMCO right down the road for me?
Paul: Yeah. So I started right after the financial crisis at PIMCO back in ’09. I was actually an MBA intern the year before. Had seen essentially the financial world crash and people freak out. Also saw brand new type of vehicle navigate and help people get through it. And PIMCO wanted to be in the ETF business. They had thought long and hard about it before but the approval of the first active ETF back around that time I think was the green light.
And so as a brand new naive and really…I didn’t even know what a ETF was at the time, I was tasked and put on a team to go build PIMCO’s ETF business. So that was a fun, I want to say, six years, built out a large active ETF, fixed income active ETF business. And then right around 2015, left after Bill Gross was effectively pushed out. Went to join Principal, where I got to launch another brand new ETF platform.
And there, I got to experience and play around with the equity side of the ledger as well. So it allowed me to get some multi-asset experience, a mix of index and active, which helped me learn a little bit more about the index side of ETFs, which is obviously the predominant side, by the way. So I sort of started in reverse, fixed income and active, worked myself into the passive side. And then really the green light for me on Simplify was the opportunity set.
Derivatives role was coming around, which changes the regulatory framework and allows a lot more use of derivatives and leverage inside of a ’40 Act, essentially levels the playing field of a mutual fund or ETF to many of the hedge fund type vehicles, private funds out there. And I thought that was a game-changer and not enough people in our industry were talking about it. I tried to actually build some internal momentum to at least look or think about it at Principal and very quickly hit a wall but doesn’t fit in neatly into the regular distribution or existing type of strategies. So when I couldn’t build it in-house, I decided, okay, well, this is a great opportunity. It’s a scary time. I quit right in the heart of COVID, March of 2020, and then filed our ETF trust and launched ultimately in September. But pressing that quit resignation button while thinking about family and healthcare and all that stuff was hard, but the opportunity was there and the timing in hindsight worked out.
Meb: In any entrepreneur venture, a bold naiveté optimism to think you can do it.
Paul: Burn the shifts.
Meb: Right. There are a couple things you talked about there that I think would be interesting before we keep going. The first was PIMCO at that time when you were there had launched the big BOND active ETF. And like you mentioned, active, A, it meant something different back then, but, two, it was the afterthought of the ETF community. And I remember you guys famously launched with an odd symbol.
Paul: TRXT.
Meb: Yeah. And I remember looking at that and being like, “Huh, these guys couldn’t come up with a better ticker?” And then magically, a month later, it switched to BOND, and the assets weren’t great until it got to BOND, and then it skyrocketed. So do you have to do some Bitcoin in a yellow manila envelope to somebody to get that or what?
Paul: No. TRXT was a ticker that, hey, look, it sort of made sense when you’re staring at a paper sheet and its total return exchange-traded. It was just the best of bad choices. And so we went with it, and very quickly, at the bell ringing actually, which was at the NYSC, and they brought a camera crew out to Newport Beach. And so Bill Gross is on trade floor with myself and Laura Morris and at the time, and one other person from PIMCO. And we’re bell ringing and celebrating the launch of TRXT. And the whole time Bill Gross is leaning over to Laura saying, “I hate this ticker. Vanguard BND has such a great ticker.” And he just kept going off on the ticker. He’s like, “Why can’t we get something like BOND?”
Meb: See, he knew it ahead of time.
Paul: Tickers matter. That’s like a URL. But a couple weeks later, magically, I don’t know, all of the details magically we were told that BOND suddenly became available and would we consider switching? We switched it. I would say TRXT was still getting the flows because I think the star power of Bill Gross and PIMCO at the time, it was just a very, very fast-growing ETF out of the gate. But BOND really helped accelerate it and was just appropriately tied to some reasonable bonding at the time. BOND makes sense. TRXT, what the hell is that?
Meb: All right. So walk us forward. You mentioned this derivatives rule. For 99.9% of listeners who don’t know what that is, explain it, what that actually did and why that was impactful?
Paul: Sure. So before that rule was passed in the U.S., mutual funds were able to use derivatives and still are, but it really limited how much. It didn’t take into account what kind of derivative it was. It just pretty much capped derivatives at notional. So you could imagine something that moves very little. Think of treasury features or something that’s relatively low volatility. If you have a certain percentage of that future, that’s it, you can’t add more than 100% gross leverage, which sounds like a lot, but it quickly taps out if you’re trying to do any sort of long-short strategies or combination exposures. It really makes it hard to do things like foreign exchange, where without leverage, it really doesn’t make a lot of exciting product potential. It limited the use of derivatives. And frankly, there’s also probably a limited demand for derivatives. People are often very scared. 2008 was fresh in people’s mind and Buffett famously called derivatives financial weapons of mass destruction.
So that stigma, I think, has largely gone away. You see single stock options and you see people freely adopt the use of derivatives. In Europe, of course, they’ve always been ahead of that with total return swaps and other derivatives’ exposures. But the regulatory switch took it from this notional cap, which made a lot of things really not that exciting to use leverage on to something that really, again, leveled the playing field, and it turned it into a VaR limit, which is a value at risk.
Now, it takes into consideration the riskiness of the exposure. So levering up T-bills or something really low volatility is very different from levering up equities or commodities or something like that. And so it takes that in levels…what does that do for people? Well, it actually makes things like long-short strategies, tail risk strategies, anywhere where you have a lot of notional but relatively modest impact day-to-day, it makes that really interesting. It makes the whole liquid alt category, which I joked was basically just a LIBOR before. It’s like LIBOR plus something, a very expensive LIBOR plus something.
And all of a sudden with the right amount of leverage, we could create products that can appreciate meaningfully, can meaningfully hedge, is balance sheet efficient. So if you’re thinking about a portfolio and you have $100 to allocate, the last thing you want to do is put a big chunk of it in something that moves a couple per cent a year. That’s wasted real estate. But if you could take a lot of that potency through leverage and put it inside, all of a sudden you could create some really, really interesting payoffs or distributions of outcomes that make it worthwhile. And I think that’s really what this regulatory shift allowed. And by the way, it’s now caught up with a regulatory framework that was in USCIS world, the European Mutual Fund land, where they were already VaR based.
So it’s catch up and leveling of different vehicles, and it was framed as modernizing this regulatory environment or framework. And it does that. It most importantly, I think, democratizes what was only available in hedge funds or CTAs or all these private funds that require essentially you to be very wealthy and now opens it up to bring into ETFs.
Meb: And at the very least, it makes a lot of the allocations more efficient. Our buddy, Corey, would talk about returns stacking and other concepts but using the combination of some of these assets in a way that ends up being lower cost or a lot more efficient than trying to do it on your own prior, which was rough. Let’s talk about a few strategies. Give us a little insight into what were some of the early strategies to launch or concepts. And we can kind of dig in on some of the other themes too.
Paul: I think our first and flagship product, we launched it as a suite of U.S. large-cap exposure, really buying S&P 500 passive ETFs. And the idea behind them was basically, look, in today’s world stock picking is hard to do and very few active managers do it. People will have embraced large-cap benchmarks like the S&P 500, which tend to beat most active managers. Year after year, we see the same scores and data. So I try to beat the passive index game.
People have already embraced it, accepted. What’s missing in the ETF world or at least, can we surgically change a distribution? So if you think about behavioral biases or preferences. My colleague, David Burns, has a very good book out. He talks about utility theory, and it’s really a downside that hurts people so much more than the psychic benefit of the upside. So can you do something about the downside while still generally giving people one beta exposure to stuff that they want?
And so SPB was that. And 99 out of 100 cases, you’re going to get this beta, and every few years something bad’s going to happen to the market. And you’ve put a little bit into options to protect, you put seatbelts around the beta. And then can you take away some of the left tail at the cost of a modest investment through the years? And just thinking about distributions of asset classes and shaping them, I think that’s really where options are really, really interesting because options give you that ability where you can have one-sided risk, understand how much you want to buy, especially if you’re long options you know exactly how much you want to spend. And then within that constraint, can you design an outcome that’s interesting? So, really, we took the S&P 500 beta exposure. The thought process was put 2% or 3% a year into “insurance,” if you will, by really deep out-of-the-money puts. You’re happy to eat it most years. And then every once in a while, it pays off.
And most importantly, it pays off and is a diversifier when you need it the most. So it’s guaranteed to be anti-correlated if you buy puts versus think about in March of 2020, bonds initially helped and very quickly sold off along with equities. The correlation flipped similarly, low vol, and all these sort of factored things that were supposed to help helped in the beginning a little bit and then failed when you needed it.
And so can you fill in that gap when the market is really down? Can you fill out an exposure that mathematically is going to give you some help and give you some ammo to buy the dip? And that’s really kind of the brainstorm behind it was beta with an option overlay, done cheaply and efficiently so someone could buy an ETF and it fits within the RA world if you think about tickers and buying ETFs versus signing up for an option overlay and getting suitability on that stuff. So that was it. It was just basically, “Let’s go out to the biggest river that we could find, U.S. large-caps. Let’s see if option overlays put inside of the ETF works. Let’s see if being long volatility instead of being short volatility is a thing. And if it isn’t, well, it’s a fun time. We’ll see what happens. If it is, who knows where this leads?” And that was it. The first three.
Meb: Do you guys do that through a traditional one-way exposure with the puts? Do you do spreads? And then I guess to assuming just varies by fund on how you go about it but with the original idea.
Paul: So the original idea was simple. If you want to spend, let’s say it’s 2% a year, that means roughly…call it 50 bps a quarter. Okay. So that sounds simple. Fifty bps of ammo each quarter, go buy some out-of-the-money puts. Well, that’s great if you buy short-term out-of-the-money puts, but guess what? More than half of the drawdowns in history are extended. So if you buy a bunch of short stuff and it takes a couple months for the market to sell off, that didn’t really help you much.
And so that was the initial idea. And then we put laddered portfolio of options instead. We said, “Look, we want to protect against multiple scenarios. Yeah, the March 2020 type of rapid drawdown, that’s a perfect world for any options. Anyone could come up with a way to protect against that. But what the heck do you do if the great depression were to happen again then you had a 80% drawdown over a year while the only thing that protects that is long-dated options? So can we split some of the budget, if you will, put some in long-dated stuff, put some in short-dated?”
So you can see how quickly it gets complicated and path-dependent. So the idea was creating an infrastructure and backtesting profile to build the right type of laddered exposures to make them robust, protect against a lot of different scenarios. And then very quickly, you come into September, October and calendar flips and implied vols go up and they stay up, and all of a sudden it’s expensive to do options. Well, for that same amount of budget, can you buy enough protection? And we go, “Well, not exactly what we’d want to protect. Let’s find more clever ways to protect.” And so all of a sudden these long puts became put spreads where you could chunk big chunks of protection but you’re offsetting it by selling some puts deeper right out of the money.
So I think that evolution and iteration of ideas, that’s expected in the active world. The active portfolio manager creates their investment process, adds talent. And over time, they invest in it and it gets bigger and bigger, a little more complicated, just scars and wounds from being in the arena. I think in our case, it’s great that these are not index strategies and that it’s a very complicated overlay to put on.
So all the secret sauces in that overlay and a lot of the secret sauce is really saying, “How the heck do you put some protection given today’s market?” And so a long-winded answer of saying each iteration gets a little bit more interesting, more complicated in a meaningfully constrained way, but we kind of think of it almost like software version 1.0. Internally, we think of it as we’re somewhere in version two and a half or so. We’d keep iterating.
Meb: I think a good analogy we talk a lot about that people assume you have to accept asset classes and outcomes prepackaged. If you buy the S&P, you have to accept it in the wrapper that is SPY. But in the reality, there’s a million different outcomes that could be designed and combined, more leveraged, less leveraged, more exposure, other outcomes with the derivatives. And so once you open up that menu, it kind of goes from in and out to the secret in and out menu of all these other choices you could do.
Okay. So there’s one that I love. It’s also one of your biggest strategies, which is also been playing out in real-time pretty quick over the last few months, which is focused on interest rates. Tell us a little bit about that strategy. Is that just a inverse of what we just talked about with stocks, or is it got a little bit different vibe?
Paul: So this one, we looked at hedging all sorts of risks. And one of the risks, obviously, when at the time fed funds are at zero, well, effectively, still the same, but rates are all-time lows, it does feel like it’s a one-sided bet that eventually interest rates will rise. How do you hedge it? Well, you had inverse treasury ETFs. You could sell futures, you could buy, put some bonds or ETFs, very expensive but doable or very linear and not really a hedge. And meanwhile, you’re eating the carry of shorting that exposure. Harley came to us, Harley Bassman, who is the lead PM on it, it was really his baby. He’s an ex-PIMCO guy, a legend Convexity Maven. He is definitely one of the foremost experts on volatility and options.
Meb: And by the way, is PIMCO giving you guys some shit about using the plus word in a lot of these?
Paul: They haven’t yet. Don’t give anyone ideas.
Meb: It’s kind like an homage. It’s like a hat tip.
Paul: It is. In the fintech or VC world, if you’re ex-Google that lends street cred to PIMCO itself, it still is this magical, talented place with a lot of big brains. But anyway, so he came to us and we pitched him initially on,” Hey, can you take a look at some of our products?” We had just launched those products. We were talking about S&P products, U.S. large-cap products. And we were hoping to get some criticism so we could iterate and address.
And he looked at it and he’s like, “Well, the downside stuff I kind of get.” But he’s like, “Whoa, one of your ETFs has upside convexity.” And he’s like, “I’ve never seen that. I’ve never seen long calls inside of a ETF like this before.” He’s like, “One, that’s brilliant, and, two, that’s really where all the value is today.” And he’s like, “I’m intrigued.” And a month later he came back and he is like, “Well, I have this really cool idea. I’ve been watching my friend, Nancy Davis, and she was crushing and still is crushing it with interest rate inflation hedge product eyeball.” And so he came to us and said, “Well, I have a different idea, much more of a straightforward interest rate hedge but it takes advantage of the most efficient way to hedge big moves and interest rates in the interest rate derivative space called swaptions.” But he’s like, “I don’t know how you would get a swaption inside an ETF. Can you guys do it? And will you launch a product with me?”
And at the time, we had just launched equity and listed option-based ETFs, and here’s this double dare, someone’s coming in saying, “Can you brand new startup shop do this massively complicated strategy that buys interest rate derivatives. And oh, by the way, requires ISDAs that aren’t really available for most entities, let alone ETF shops. And can you do it this year so we could take advantage of the interest rate situation?” I said, “Okay. Yes, we could do it. We’ll figure out how once we start.” And that was it. It was basically, we decided we’re going to figure it out. And he calls it Formula One racer. He’s like, “This is basically taking hedge fund-type exposures, the stuff that PIMCO PMs would use inside of their portfolios express views, putting it inside of an ETF so that PIMCO civilians could access it and really democratize that exposure.
But it also solved a big investment problem, which is how the heck do you hedge a portfolio against rising rates without incurring a ton of negative carry costs and take advantage of this really unique opportunity and swaptions where the vols surface is kinked. There’s a lot more supply of options than buyers on and on and on. And we did it and we can’t do it all the time because let me tell you, ISDA-based exposures, you don’t go to a screen and go type in a bond or a stock ticker and go buy it. You have to actually buy an OTC. And it’s just a lingo and the infrastructure to trade ISDA-based product. Again, a lot of managers can do it. Very few I think in the ETF world can do it, but it was an interesting thing to go through. And now, that opened up our capability to do ISDAs with a number of other, one, banks, but, two, on different exposures, like total return swaps on equities. And all of a sudden, long-short exposures, lever exposures become possible, at least. And then it opens up the product development toolkit.
Meb: Some of these funds, I imagine are more niche than others. Some are tactical, some are all the time that investors will use. What’s the most traditional way people are using the interest rate hedge? They’re putting it on currently just for a bet as interest rates environment they’re nervous about? Are they trying to switch it out for an all the time alt exposure, or is it different strokes, different folks?
Paul: It’s meant to be a strategic hedge. i.e., look, investors have a lot more duration risk, not just in their fixed income, but in actually most of their risk assets. If you buy Tesla or basically anything that has long-term profits down the road, i.e., tech or growth stocks, they have a lot of sensitivity to interest rates because the valuation is really based on discounted cash flows. And if all those cash flows are in the future, it matters what discount rate you do.
And you see that. It’s not a perfect relationship, but you see when rates go up, the NASDAQ 100 and any tech names tend to go down. And so if you think about a way to hedge an existing portfolio of mostly risk assets, is there an efficient way to take out at least that one risk of a very significant increase in rates? And I think that’s it, it’s sort of a strategic interest rate hedge. It’s not saying this is a high probability, but if you see rates go up to 4% or 5%, which, by the way, is historically normal, if we see normalized rates in the next couple of years, this will do a heck of a job and is a very convex protection. i.e., the fund could go not up 10% or 20% but in the hundreds of percent in that outcome. And in that case, it does look more like a structured option, a hedge for a portfolio. And we don’t intend this to be a day trading. How do you express a view? Well, it’s a bunch of interest rate options. You may have an investment process, but we’re not trying to tell you or suggest that’s the appropriate use of this. This truly is a portfolio level interest rate hedge
Meb: Out of all the funds you guys have launched thus far and strategies, how much has been informed by you guys, putting your heads together, brainstorming, coming up with ideas you really like? And are some of these actually investor-informed where you put out a handful of funds, people are talking to you and they’re like, “No, you know what I really need is this.” And then you guys go, “Okay, let’s launch it. Sure.” Is it both?
Paul: I think it’s all of the above. And it’s also just when you throw passionate, smart people into a room, you get weird combos back. So a lot of it is just talking and, “Hey, wouldn’t it be great to this?” Or, “Have you thought about this?” And blending people with very different backgrounds. We have head of risk from Convexity Capital who did a lot of option-based stuff for endowments, $18 billion in their peak. And so they had some early experience with using derivatives of convexity at Convexity Capital. Obviously, the PIMCO world, where the use of various interest rate derivatives, levering up your dollars, and levering up different parts of the curve for a carry trade or roll down trade, just a different way of looking at the investment world and opportunity set. Like, that’s definitely in our DNA. And then you have people like Harley who lived and breathed market-making.
So they’re constantly taking the perspective of what risk and where could I lay this off and who would be a natural buyer? Where’s the supply and demand of this stuff? So can you get this exposure? And can you structure it? Is there an edge in the portfolio construction? And then you have people like Mike Green who’s out there talking market structure. Why isn’t the market recognizing that the game has changed? Is there some underappreciated risk? Is there some change in the market structure that makes some exposure interesting?
We throw that all in a mix and then if the client’s saying, “Well, that’s great. Thank you for helping us with our equities,” we really have a bigger problem on the credit side. I would never take credit solo. It’s always been whoever comes up with an idea and then the iteration of the idea goes back and forth. And then the one thing I can claim is for most of these, I grabbed a ticker, so that’s been fun.
Meb: You got two of my favorite. Knowing my background, do you know what my single favorite is?
Paul: CYA?
Meb: Close. CTA.
Paul: Oh, CTA. We just launched that today.
Meb: Oh, really?
Paul: Yeah. That’s today.
Meb: I was going to give you a hard time because it’s your smallest fun, which makes sense because it’s just launched, but I was going to be like, “Man, you got the best ticker.” I’m a trend follower through and through. And so that’s definitely been in my requested ticker list for years. And I’m like, “Who the hell has this?” Okay. But CTA is my favorite, obviously, but up there was CDX. Tell me about this strategy. What’s the high-yield credit hedge ETF doing?
Paul: Sure. Here’s this perfect case study of, again, all these smart people iterating. So, initially, after Harley launched PFIX, which is the interest rate hedge, I thought it’d be cool to come up with a credit hedge for portfolios as well, buy some options. That makes sense. Something that’s convex that could help an entire portfolio. Again, makes sense. But when you actually go and try to do it, it’s not a very liquid market. Even the CDX option side isn’t very deep relative to just CDX itself, which are swaps.
And that’s not very complex, at least from what we’re looking to do. And it’s hard to implement. And so thinking about stuff like buying puts on HYG or some other ETFs and all the iterations, the negative carry associated with buying protection through relatively illiquid markets just didn’t make the math work. It wasn’t that exciting. So we had filed it and we pulled off, kept a ticker, went back to the drawing board.
And Mike Green was an instrumental hire here. He joined a few months after Harley, and he talked about now that we have ISDAs, we could do long-short exposures. And a really good proxy for credit hedge is being long one thing and short the other and the equity side. And that is one really attractive carry relative to buying options. You don’t have to imply vols of having to pay a premium. And during very, very significant selloffs like ’08 and others, it really is anti-correlated to credit.
So if you’re a long quality and you’re short a bunch of lever junk names in a credit situation, guess what? The lever junk names, trade distress, and they sell-off relative to quality balance sheets and profitable business models. And so that’s the basic punch line. Put a little bit of that on top of a beta of high yield ETFs, put a little bit where appropriate, put spreads or a little bit of options. All of a sudden, you got something that essentially delivers you the beta, has a neutral to positive carrying credit hedge that reacts well and is anti-correlated.
And the whole thing seeks to keep the income of what a traditional high yield exposure is. So you solve the problem, you build and find an attractive hedge that’s made possible because we had built this formula one racer for Harley on interest rate hedging. And that’s this flywheel of building a business, hiring interesting people, putting them together and just random solutions come out of things that you would never have imagined.
Meb: You mentioned being a young shop, it’s going to be fun to watch. It’s pretty impressive the growth you guys have seen already because I feel like particularly with strategies like y’all are doing, a lot of people adopt a little bit of a wait and see attitude with, “Hey, this is scary. It’s got options or swaps or swaptions.” I don’t understand either of those and you mix them together. And I don’t really understand that word. I feel like a lot of people would say. But as you get more and more track record, I think as people see how they behave during market events, people can certainly get more comfortable.
Paul: Exactly. A fellow issuer, Innovators, they came out and they really navigated the 2018 sell-off and their business boomed after that because their buffered strategies were perfectly positioned to take advantage of a 25% sell-off. Perfect breakpoints, great timely market and they benefited. So a lot of our business is really getting products built that solve solutions but waiting for them to be battle-tested. To your point, everything sounds good. There’s a million ideas and lot of ways to build a mousetrap, but people want to see if it catches some mice first and then they’ll pile in. So it’s a very convex payoff. You could have a fund that sits at 50 million for a year or two, and then you get a WisdomTree caught with hedged Japanese equities. Well, not too many examples of that, but that’s the hope.
Meb: You guys have a really nice advisor corner on your website for the professionals out there. What’s been the feedback as you talk to a lot of these advisors here in March 2022? Is there a consistent theme they’re worried most about? Is it inflation? Is it U.S. stock market going down? I imagine it changes by the day now. I’m excited for when you guys are going to launch the wheat upside convexity ETF.
Paul: Too hard.
Meb: Yeah, I know. What are the conversations like? What’s everybody thinking about, worried about?
Paul: It’s funny because it’s not just advisors, and this is institutions, it’s at every level. It’s really at an individual level too. If you think about your ultimate investment goals, it’s generally is trying to drive good risk-adjusted returns or income. And everyone faces the same investment opportunity set more or less. You have really pricey equities. You have really low yielding bonds and you have a lot of credit risk embedded in everything. So now, how you solve that is a conundrum for everybody. Chasing yield, going into nichey exposures, going private funds, going crypto, but it’s all to solve the same type of underlying problem. And so the problem of really not a lot of attractive sources of returns and income, problem of knowing you’re stepping into a very risky high-valuation scenario where there’s a lot of downside risk, knowing you’re in the tail end of a bull market yet being forced to invest means downside hedges and things like that are interesting.
Knowing that bonds have a lot less room to drop and help portfolios and having seen bonds correlations flip and seeing inflation pick up, how the heck do you diversify your portfolio today? And it’s the same problem. Whether you’re the largest pension in the world, or you are a $10 billion RA, or you’re $5 million advisor, it’s the same exact problems. And I think what’s cool about the ETF business is that we could solve very similar problems. And while we target the advisor, we’re talking to big institutions too. They’re not necessarily going to pull a trigger on a small ETF, but they, I think, are always doing their homework as well. And they may try to either get the CTFs at a later date, or they may try to get this in a separate account, or they might go to their bank or whatever to structure something. We’re all trying to solve the same problems.
Meb: I love some of y’all’s fun names because a couple of these, I don’t know which one has the longest names, but some of these have 12 words in them. For example, you have the Simplify Equity PLUS GBTC. You say it in the name, here’s what we’re going to do. Tell us about that fun real quick because I feel like a lot of people have tried to negotiate this crypto world and figure out how to add to something. This concept of efficiency and return stacking I think is illustrated here thoughtfully. How’d you guys put it together and why’d you end up choosing GBTC?
Paul: So the basic gist is get people off zero, give advisors a way to get their clients some exposure to digital assets, crypto, or in this case, Bitcoin through grade scale so that they have some exposure but fit it into the traditional financial infrastructure, so you could type it into your current risk platform and get metrics and automatic portfolio balancing access, all that stuff. That’s the desire for an ETF.
We have approximately a 10% allocation to Grayscale. We chose Grayscale because we didn’t have a lot of choices of ways to get crypto or Bitcoin exposure. When we listed this product, we were basically told you could use up to 15% of Grayscale. You could file for Bitcoin futures, which was not yet approved, or basically buy some proxy or something. It really wasn’t a lot of choices. We couldn’t go into the international ETF market, and we couldn’t hold physical or futures directly ourselves.
So that, again, expresses the challenge of getting exposure to something that has been a really positive asset class for many is diversifier. And it’s working well in this sort of environment today where you have a lot of concern about inflation. And it’s just a way for people to get some diversifier into their portfolio. We put it together, given all those constraints, we couldn’t make 100% Bitcoin strategy. So the idea was to help people get off zero within the SEC limitations but in a thoughtful way where for every dollar of U.S. large-cap exposure, you put 10 cents of this Bitcoin exposure and overlay it, so you’re not really having to sell or change your portfolio allocations. It truly is a diversifier. We’ll do all the balancing for you. And to the extent that Grayscale trades at a discount, we’re buying it in the market for a massive NAV discount.
If they ever were to get approval to turn into ETF, that collapses and that’s sort of a benefit. We manage the tax through in-kind redemption, so the volatility and rebalancing is tax-efficient and ETF vehicle. And it’s a one-allocation and done way to get a targeted percentage. If you wanted 1% in Bitcoin, you put 10% of your portfolio into this U.S. large-cap exposure. And that 1% will be rebalanced for you automatically. If Bitcoin triples in price, this fund will naturally sell it down in a tax-efficient way. No worries about K-1s or anything. It’s going to work.
That was the idea. I would say it’s gotten decent early traction, but it hasn’t been as revolutionary or passive gathering as it could have been. I think we’re still in the early days. And I think from a access point, there’s a lot of competing ways to get access to Bitcoins, including now futures-based strategy. So I think we’re still in the very early innings of how to mainstream crypto. I think we’ll see what that looks like. But at the minimum, getting people off zero is probably something to think about.
Meb: We’ve mentioned this on the podcast, not investment advice, of course, but the GBTC is interesting to me as our most closed in funds. But this one in particular, in your fund, I assume will have a natural way to do this because it trades at a discount. Theoretically, if you have a risk-off environment, day, week, month, or more, and that discount blows out even more, you guys presumably would be…
Paul: Rebalancing.
Meb: …rebalancing. So you’re adding more as it goes down. And we talked about this during the COVID pandemic with Ackman’s Fund and backend, the financial crisis with Third Point and others, where they can get to these 50% plus discounts and net asset value. And so while some of these funds may have higher expense ratios, you’re not going to be holding them for 10 years. And I don’t know what the eventual spot approval is. It’s not five years, it’s probably one or two. And so that 30% discount where it’s trading. I said an interesting idea would just be, first, you can just buy this fund but second, you could put in limit orders every 10% down. If they get hit in a panic, you end up with a discount NAV at 40, 50, 60, 70, all the way down.
Paul: Yeah, which applies to any of this closed-end fund-type structure. It just reflects liquidity. Honestly, you could say the same about certain ETFs, like credit ETFs in March traded down 10%, 15% discount. So it’s just a scramble for liquidity at that point. But the other thing was the Bitcoin futures has a curve. So that’s a negative carry. At the time, it was in the 20s. So an annual cost of holding a futures-based strategy was adding a 20% drag versus cost of holding physical Bitcoin. So you trade off a 2% expense ratio but physical plus the benefit of a discount, or a future-based strategy that was a little bit cheaper, yet had this massive headwind on this carrying cost. It’s interesting. That’s, again, the benefit of ETF vehicle and the ETF market is there’s so many different things you could do and get access.
Meb: Which one of your strategies is one that you love and hasn’t had the reception or the assets flow yet, where you guys are expecting like, “Man, I love this strategy but no one else does”?
Paul: The one that stands out because it has no options or derivatives here is our ticker PINK. It’s a healthcare ETF and it’s beating most of the healthcare competitors. It’s massively based on active manager guy named Mike Taylor who ran giant healthcare books for Citadel and Millennium. He retired and he basically did this pro bono, and we’re donating our entire higher expense ratio over to Susan G. Komen once a year.
And I’d love this to get big. It doesn’t bring a scent of profit to us, but the cool thing of creating essentially an endowment ETF that we hope that we could use to write checks for a cause that many of us find dear because a bunch of us have family or some of us have directly had cancer and survived. It’s been really interesting contrast the rest of our lineup, and we do have plenty of females, but we don’t have moms. And so this is definitely something that was cool.
And the whole idea came around and we got it launched right at the tail of October, which is Breast Cancer Awareness Month. The NYSE Doug Jonas found a way to schedule a bell ringing. And so we got to get a bell ringing in October and it’s been fun. It’s not as big as it deserves to be in my view, both for the cause, but really just on sheer performance. It’s sitting right under 30 million bucks, but, like, Taylor’s just been hitting it out of the park.
Meb: Interesting thing here is…and this is the theme that I am surprised. We talked about this maybe a decade ago. It hasn’t seen more traction where…and this is a perfect scenario. You have a vehicle where there is an argument to be made for the actual annoying strategy. On top of that, it’s cause-driven. So you have all the ESG, etc., out there, but in this case, it’s actually all the profits go. And so I’m surprised, actually, you haven’t seen more organizations either where they do it on their own or partner with PMs or other people to deliver product where it would benefit the actual underlying. I think that’s an inevitability. You’ve seen a couple over the years, but none have really scaled to the size where I think would really seem like it would be an obvious idea.
Paul: And I agree with you. I think the world has gotten so polarized. So I think even at charity, it’s really hard to find a charity to that doesn’t divide people, which is crazy. Well, that’s where we are today. So that’s part of it. And I think, in this case, it’s really hard to find too many people who are pissed off about trying to beat cancer or breast cancer, but they’ve had controversy in the past too.
Meb: It’s 2022. I’m sure on Twitter, you could find plenty of people.
Paul: Exactly, which is…I think that’s some of it. And then a lot of it is I think ESG’s been still very narrowly focused. If you really think about it, it’s mostly been climate change really. Everything else has been a sideshow. So this is not a climate change ETF. It doesn’t neatly fit into institutional mandates. There isn’t as big institution ready to write a check yet, but maybe that changes and this is at least an attempt at doing something interesting really hopefully meaningfully impactful. And at the minimum, something that all of us really take personally. And it’s actually helped recruit too because it’s one of the first funds that our candidates see and they’re like, “Well, it’s cool that you guys seem really smart. Oh, that’s great.” That doesn’t fit in but that explains a lot.
Meb: So, as we look to the horizon, I’m sure you can’t or won’t, but we can try, what are things you guys thinking about on these fun rollouts, but also simplify in general, as you think about building this company?
Paul: ETFs. They’re like blockbusters, you don’t know what’s going to be a blockbuster. You could try your best. It sounds great on paper, you don’t know till you’re in the arena. The right situation, the right market environment, money, motion, the right theme, whatever, all of that needs to come together. So there’s an element of that. And if you have 20 something ETFs, some of these will hit and become relatively attractive.
So that’s an interesting level one to play. But really, what we’re focusing on is how do we combine these things where we could disrupt not individual ETFs, but really how people think about portfolios? If you put non-linear exposures and return stacking and other concepts, all of a sudden all of the stuff that people have relied on, your balanced portfolios with 100% exposure, no leverage, non-linear exposures, just truly diversified asset classes, that I think is up for at least some…I don’t know about attack, but there’s some danger to that one way of thinking. And I think if you think about all of the ways investment products are distributed today, a lot of it is default stuff and tail risk strategies, retirement, or very similar-looking risk-based portfolios and four decades of falling interest rates and generally attractive equity returns that’s lent itself really well for that 60, 40-view or very bond and equity-focused view.
All of a sudden, inflation’s back, geopolitical risk is back and market structure is weird or broken. Is there an opportunity to pitch something different at the portfolio level? And I think that’s really where I get really excited. It’s less about winning a better S&P product or high-yield product or something. It’s really about, can we help build better portfolios that help get someone from first year of work all the way to retirement, more thoughtfully, hopefully, leave them with more assets later and smoothen them out the ride? Is there more opportunity there?
And I think that’s really where we want to position ourselves, go into the retirement world, go into the model’s world, go into pitch how people think about and construct glide paths and really try to evangelize on going beyond sharp ratios and very linear views but think about downside risks and nonlinear payoffs. Are there thoughtful ways to revisit the portfolio construction? That’s where I think it’s really cool and not enough people are doing that sort of thinking in the ETF world.
Meb: Any point in the last eight years? I would’ve said this conversation between you and I would probably fall more on…
Paul: Wishful thinking.
Meb: Right. But the last year, people waking up again to some outcomes that aren’t as pleasant, or they may need to think about a bit.
Paul: Not a layup. If you’re a poker player, like, the setup is good for something to happen. It still means you got to draw the cards, means the market has to play out, bond yields have to go up and things have to break. But at least there’s this window that’s open now and people are willing to at least think about it because desperate times require desperate measures.
Meb: In the one or two week lag time between when this podcast gets recorded and comes out, it may be already out of date with what’s going on in the world. Anything else you’re thinking about in the entire investment space, excited, confused, worried about, concerned, totally ambivalent about? It could be policy, it could be ETFs, it could be investments, other areas ripe for disruption that haven’t been. What’s on your brain?
Paul: I think it’s just a general disruption, the word disruption. And you’re seeing it in every industry. Finance is no different. Fintech, for sure, but ETFs are kind of the fintech of asset management. We’re kind of bringing people that may not have made it through the traditional feeders and were bringing strategies that would have gotten rejected just on day one into the market and letting the market really figure it out. And then you also have a open group of clients in the form of RAs who have discretion and who are also competing and trying to deliver really interesting outcomes. And so you don’t need to convince everybody, you don’t need to convince a gigantic company made of committees. You just need to convince and find a thoughtful equivalent in the advisor side and a handful of those advisors can control enough money to help a small startup, like, just get off the ground and I think that’s it.
And in previous days, it would’ve been really hard to find that needle in the haystack. But I think today, given the advent of advertising digital media, webinar, Zoom, it’s become at least a little more realistic to find those pockets of early adopters and people who think about the investment world in like pointed ways. And I think that’s it. Ironically, even though COVID was such a scary time to launch a business, I don’t know if we could have had the success pre-COVID because Zoom wasn’t available. We’d have to be flying around to visors and doing one or two meetings a day max. Good luck scaling that on a very limited startup budget when you could hit a dozen a day from the comforts of home and not cost anything. That’s a pretty powerful thing. And I think that’s great because that means it democratizes ideas, it democratizes access, matching buyer to seller in an interesting way. And that’s, again, very doable today and not so doable back in the day.
Meb: All right, listeners, all the advisors out there, Paul just volunteered to do a personal Zoom with any of you and talk about your portfolio.
Paul: Meb will screen first.
Meb: But you got to guarantee to get CTA up in size. What’s been your most memorable investment looking back on your career, good, bad, in-between, anything come to mind?
Paul: This is that behavioral thing again. You remember the loss is more than the gains. And so I remember betting against the fed and shorting the market and trying to be clever and seeing the market and fed stimulus just drive my portfolio returns down because I was betting the other way. And so I’ve learned never to try to outthink the market in that way. So you sort of embrace the distribution of the market and you could be clever about structuring trades and outcomes on the side, but that’s a philosophical view. It’s really hard to pick stocks, at least for me. And I prefer to try to create interesting hedges and outcomes to think about things in a probabilistic perspective.
Meb: Where’s the best place people to find you, set up that Zoom call, they want to buy your ETFs, where do they go?
Paul: Come out to www.simplify.us and just click on one of those webinar, or schedule a call links and take it from there.
Meb: Awesome. Thanks so much for joining us today.
Paul: Thanks.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at feedback@themebfabershow.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.
