Jerry Peters, Managing Partner, Smithbrook, LLC

[00:00:00] Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital and the alternative investment industry.

[00:00:16] The rule of 72 tells us that a good approximation for the time it takes to double your money can be arrived at by taking 72 and dividing by the interest rate the capital can compound by on an annual basis.

[00:00:32] Implicit in the calculation is that the initial stack is left untouched and is not vulnerable to a drawdown. In this context it was great to welcome Jerry Peters, the managing partner of Smithbrook to the Alpha Exchange.

[00:00:44] Providing a risk managed equity solution to its high net worth clients, Jerry and team are focused on managing downside risk, utilizing an option overlay strategy to mitigate some of the inevitable swoon and equity prices. Our conversation walks through how index put options, when acquired at the right price,

[00:01:02] can create gains that help offset portfolio losses during times of stress. Acknowledging that the long term expected value of buying insurance ought to be negative, Jerry walks through how a protective strategy can interact with long exposure to create long term return enhancement.

[00:01:19] Heary points to how gains from insurance during sell-offs can underpin the quote rebalancing bonus, where capital is moved from winning to losing assets on a systematic basis. We also talk about some of the subtle aspects of financial asset taxation and efforts to

[00:01:34] maximize not just the pre-tax but also the after-tax return of investment decisions. Jerry details some straightforward tax loss harvesting strategies that can add meaningfully to investment outcomes on an after-tax basis. I hope you enjoyed this episode of the Alpha Exchange, my conversation with Jerry Peters.

[00:01:54] My guest today on the Alpha Exchange is Jerry Peters. He is the managing partner at Smithbrook, an investment vehicle catering to high net worth individuals. Jerry, it's great to have you as a guest on the podcast today. Yeah, thanks, Dean. Thanks for having me.

[00:02:08] It's great just to be speaking with you. Looking forward to the conversation we were introduced by Devon Anderson, another podcast guest and an expert in derivatives. That'll be a big part of our conversation is utilizing derivatives for risk management purposes.

[00:02:26] That's at the heart of the Smithbrook philosophy on risk. Let's get our conversation going and learn a little bit more about you and your background. You've spent many years on the buy side and in the money management business, going back to Quellos and BlackRock.

[00:02:41] Give us a sense as to your career path and how it came to be that you are running Smithbrook. Yeah, I have many years in the business. I started my career in the mid-90s actually on the sell side.

[00:02:54] I was trading convertible bonds at Merrill Lynch in Japan and Japan was the largest convertible bond market in the world at the time and my primary trading counterparties were the deaths at some of the prominent hedge funds at the time.

[00:03:07] So long from capital and Citadel, Starter, Khyberge and HBK, those sort of funds. So I started my career there working with the gamut traders of the time. In the 2000s, I moved back to the US and that's when I joined a fund of hedge funds which was

[00:03:24] Quellos and subsequently became BlackRock. We invested in hedge funds, ball types and so relative value, event driven, hedged equity kind of all the rest of it. In the 2010s then I kind of shifted and I moved to the family office side.

[00:03:40] I joined a multifamily office and started working with high net worth families. So they're taxable investors and that was kind of a new dimension for me at the time to be thinking about tax consequences as we put together the investment strategies and portfolios.

[00:03:54] And I became the CIO there at the multifamily office and let me just give you one anecdote about that time it kind of leads to the why we formed Smithbrook. We had a problem there in the teens and it was a zero interest rate environment.

[00:04:10] The Fed had its peg to zero which obviously had some pretty severe implications for our bond part of our portfolios. There was an asymmetry to bonds and I would say it was upside down.

[00:04:23] So return free risk was what we had at the time and that caused us to start looking for other ways to try to diversify the equity risk in our portfolios without relying on bonds.

[00:04:36] And we looked at a lot of different programs at the time, different hedge fund strategies, tail hedging strategies, trend following and different overlay strategies as well. And that's actually when I came across Zed Francis who's a partner of Devon Anderson

[00:04:54] who was on your podcast here a few weeks back. And Zed was running an overlay strategy that was interesting. It was short delta and long gamma. And that was potentially interesting for a taxable investment portfolio because obviously the short delta exposure helped diversify our equity

[00:05:12] risk. This strategy was likely to produce cash when the market was down which supports our for regular rebalancing strategies. And then we also saw it as a way to potentially turbo charge our tax loss harvesting efforts. So interesting in a lot of ways, but we ultimately

[00:05:29] did not move forward with them. And I say the problem was mostly on our side, gamut trading as a very active strategy. There's kind of regular monetization of the exposures and we just

[00:05:41] didn't have the systems in place, the trading systems in place to be able to implement that in our portfolios. So anyway, in 2020 we ended up selling our family office practice and I left at the time and then with my business partner, we started Smithbrook

[00:05:59] and we set up Smithbrook in a way where we'd have those risk systems and trading systems in place in order to be able to manage the derivative overlays in combination with equity portfolios and to do it in a way that makes sense for taxable investors. So

[00:06:16] along with an introduction to say what we're all about at Smithbrook is trying to bring that high finance of equity derivatives to high net worth individuals. Yeah, I think what's so useful and interesting about the derivatives market, especially in so far as

[00:06:34] overlaying the shapes that you can create on an equity portfolio is just this idea of risk management. You mentioned the short delta long gamma profile. Well, I'll tell you, short delta short gamma is me getting my kids up and out for school each morning.

[00:06:55] A little bit of both of those. I wanted to go all the way back to that convertible bond market in Japan just to chat about that a little bit because it is really an interesting time period, a very vibrant market. You mentioned some of those who's who convert

[00:07:10] ARB accounts from the 90s and still many of them are active today. I also noted that you have a degree in Japanese. I thought that was just super interesting. So tell me a little bit about

[00:07:22] that time. As I said, it was obviously a lot of actual ARB trading in those bonds back then. I'd love to just hear a little bit more about your experience then.

[00:07:31] Yeah. You're going to take me way back then. I was born in the 70s, so I grew up in the 80s there. And if you remember back to what was going on then, it was Japan Inc. Japan was taking over

[00:07:44] the world and there was the Niki bubble at the time. And obviously with the soaring equity markets, that was a very favorable time for issuers to be issuing converts to take advantage of

[00:07:55] those equity valuations. And so what we saw in the late 80s and early 90s was just a massive explosion in the convert market in Japan. And then at the same time, it was really a heyday for

[00:08:09] the convert arbitrageurs. So Princeton Newport Partners was probably one of the pioneers in that space, but Citadel and Long-Term Capital, all those groups, obviously there was just cheap embedded options in these converts. And there was such a supply there. So my role to kind

[00:08:27] of go into the details of it, I actually wasn't trading the options. I was stripping out the credit risk from the converts. So we'd say we put together the happy meal for the hedge fund managers. We would

[00:08:40] help them source the bonds and the equity hedge. And then the third part of the happy meals, we would source the credit hedge. So I would buy the credit out of the bonds and place that with

[00:08:50] Japanese fixed income investors. And then these convert bond hedge fund managers were left just with these options. And these were long dated options, five year, seven year options that were fully hedged and they just had to trade the gamma. And it was just a moneymaker. And so

[00:09:06] at the time, Long-Term was always the most aggressive. They had the biggest positions. And obviously they had their troubles in 98. But as we understand it, this part of their

[00:09:16] book was, I think the only part of their book that was profitable or at least one of the only parts of the books that was profitable. So that kind of fortunate to have a front row seat there to be

[00:09:26] part of that. And winding that book, a long-terms book after 98 was just a fortunate time for me to get a front row seat to all that. It was a heyday for convert hedging. And as it is with

[00:09:38] most alpha strategies, when the pickings are rich, then it draws in more participants and the strategies evolved a lot now. You can't as easily strip out all the risks and be left with

[00:09:48] the cheap option today. But back in the time, you could do that. I love the happy meal description. But there really was a fair amount of financial engineering there and that asset swap market was

[00:10:01] valuable. It's almost like finance at its best in that sense of finding a home for the risks that will be most valued by different types of investors. And that's really a lot of what the

[00:10:14] S&P options market enables as well. There's quite an array of participants in the S&P options market. It's deep, it's global. You have buyers and sellers active at different points along the surface, meaning both across strike and across time and just various use cases

[00:10:36] for it. And I think that's really what makes it so valuable as it draws in participants trying to accomplish different things. So let's dive into some of how you think about risk managed equity.

[00:10:49] I want to set the stage a little bit here because I see in some of your work, you talk about drawdowns. That's a big part of your philosophy. You'd mentioned those bad old days of

[00:11:01] 2% tenure yields and a policy rate pinned to zero and really trying to suck blood from a stone in terms of generating some yield. There's this old little trick called the rule of 72. You take 72, you divide

[00:11:16] by your interest rate and that'll tell you how long it'll take your money to double. Of course, the exercise there implies that your stack never has a drawdown. So if it's a 4% rate, 72 divided

[00:11:28] by 14, your money's going to double in 18 years, but that assumes you don't have a drawdown. And I think that's a big part of what your goal is at Smithbrook. So why don't you walk us through a little

[00:11:39] bit of the strategy and how you think about it and how it incorporates some of the almost philosophical tenants you have on risk? Let me dive into that. I just want to make one comment

[00:11:49] too on what you had mentioned there about the S&P market. It just resonated with me. I think there's certain factors that drive a permanence to the inefficiencies in markets. And one of those is the market segmentation, where you have different participants with different

[00:12:05] viewpoints participating in the same instruments, but they have a different view as to what the value is. And that interaction between different market segments is like a creates a persistence inefficiency. And that is one of the opportunities that we see in S&P options,

[00:12:22] which is part of our strategy. So our strategy is actually pretty simple. We combine three sources of return in a single separately managed account. The first strategy is just to have long beta.

[00:12:35] We use S&P 500 for our long beta, but it really could be anything. Then the second is S&P options or options on the S&P. And just to be clear, we outsource this piece.

[00:12:47] We use convexitas for their tail liquidity strategy. It's a complicated space and I think being an expert in that space is in the day to day, it matters. But what we're looking for

[00:12:57] is a return stream there that has a certain profile. And what we are interested in particular, to your point, is to try to help us manage the drawdown tax. So we know drawdowns drag down

[00:13:10] our compounded annual growth rate. So what are we going to do to try to manage that? Well, the overlay strategy using S&P options has a certain profile. Within guardrails, it will always have a delta between zero and minus one. And it will always be long gamma.

[00:13:28] So we know what to expect from that part of the portfolio. And then the third part of it is to manage the interaction between the first two pieces. So as the overlay moves inversely

[00:13:42] to equities, so it tends to have gains when equity markets are down and vice versa. With an overlay strategy that's long gamma, those gains are regularly monetized. So we're regularly in the

[00:13:53] market using cash to buy equities when the markets are down and trimming when the markets are up. And so in a sense, we're actually harvesting the equity gamma alongside the gamma from the

[00:14:05] option strategy. And then the last layer of that is that we do it while staying aware of the tax consequences. So if we can rebalance the risk in the portfolio, keep it to that targeted profile

[00:14:20] that we want and do it while limiting the tax consequences or even potentially creating a tax benefit, then we try to do that. So the philosophy at the root is we're trying to

[00:14:33] compound capital through time. We know that the path to do that, the right measuring stick we should use to kind of measure our success towards that objective is the compounded annual growth rate. We know drawdowns have a disproportionate effect in dragging down the compounded annual growth rate.

[00:14:53] So we take steps to kind of optimize for targeting a high compounded growth rate. We have a long beta as for growth engine. We have an overlay to mitigate drawdowns and then we try to

[00:15:06] just minimize the costs and all the taxes that are involved with managing a portfolio. Compounding is one of my absolute favorite words. And I remember when I was a student in college,

[00:15:18] one of my professors suggested that it was Ben Franklin who had the following to say he said, money makes money and the money makes more money. And that was Ben Franklin on compound interest and

[00:15:32] that always stayed with me. And so it's really the drawdowns can be critical and devastating. And so I'll just throw a couple of a match in. I'd love for you to just reflect on them a little

[00:15:44] bit. So NOV 2007 to March 2009, that's a 50% drawdown. Of course, you got the tech bust in and around the turn of getting into this century. So SEP 2000 to February 3 is 44%. And then just back to the GFC drawdown, it took you basically four years

[00:16:04] to get back to even. And I've seen in some of your writing that the loss of time is another just really detrimental aspect in terms of building wealth over time.

[00:16:16] Yeah, yeah. We do think of drawdowns as a tax on the portfolio and that tax comes in two ways. First, it's just math. Drawdowns erode the capital base of the portfolio. And so if you lose 50%,

[00:16:31] like in one of those times, then obviously you need 100% gain to get back to where you were. So a tax by eroding the capital base is the first way that it just diminishes your compounded growth rate. But to your point, there's also the aspect of lost time where

[00:16:50] the time spent in purgatory of recovering from that drawdown that you experienced is time that's lost. And as we know, time is perfectly scarce. We don't get that back. And so if you can minimize

[00:17:03] both the magnitude of that drawdown and the time spent in that purgatory of recovery, then those are just two of the most powerful things you can do to preserve your compounded growth rates. So I think most finance professionals understand this, but more broadly in the wealth

[00:17:20] management world though, I don't know how deeply people understand just how impactful those drawdowns are. But that's certainly something that's kind of core to our thinking is that first and foremost, we need to manage the drawdowns. You know, each of these drawdowns is unique,

[00:17:36] certainly in terms of magnitude, in terms of duration. The incredibly sharp and sudden drawdown of the COVID crisis really was frightening in terms of the volatility it introduced into the system of assets. And of course, the Fed and the government saw this as such an emergency

[00:17:58] that they were able to actually get the S&P back to its February level just months later. So it's almost like a nothing done type of thing. But you do have other periods we cited the GFC where

[00:18:10] the time it takes to get back to the previous high is many, many years. I'd be curious if you can reflect on the way in which your hedges are intended to work. Are they intended to

[00:18:26] reduce volatility in the portfolio? Are they intended to try to stave off a large drawdown, maybe some combination? Everyone's hedge is a little different. Some people like to attach at the money or they'll use a put spread. Others are buying true disaster or crash insurance.

[00:18:47] How do you guys think about the implementation of the downside hedge? So the strategy that we use, it's long gamma. It's not a tail hedge. It's not relying on ball expansion. All we're looking for is for there to be movement in the markets. If there's

[00:19:07] movement in the markets, then that tends to present opportunities to monetize both on the option side and on the equity side of our portfolio simply through rebalancing. So first and foremost, we want to rely on principles that we know will work not just today,

[00:19:29] but will work 20 years from now, 50 years from now, 100 years from now. So there's three things that we lean on there. The first is we want to have diversification and not just kind of a hope that things will be uncorrelated. We really want something that's

[00:19:45] reliably negatively correlated. So the hedge that we use being short S&P options, which is tied to the long side of the portfolio, which is long S&P, we have something that's linked but is a

[00:20:00] contrasting exposure. So first of all, we want that hedge to be a diverse fire in the sense that we can rely on that to be, not every time, but to be mostly up when the equity markets are down.

[00:20:13] That's the first way that it will defend the portfolio from experiencing drawdowns. Then the second thing that we're looking for from that strategy is we want to capture a rebalancing bonus. So the second thing we know will work now and we know will work 100 years

[00:20:30] from now is that rebalancing opposing assets, even if each of those assets had a zero expected return, if you combine those two opposing assets and they behave differently, then we can rebalance

[00:20:45] and actually earn a positive return. So we want to be in a position where we can monetize, not just the big moves. We want to be able to monetize even the sharp moves like March of 2020

[00:20:59] where a dip and two weeks later, we're back to where it was. As you say, so we want to be in a position where we just make small incremental adjustments with each market movement and have cash available

[00:21:11] to redeploy. So rebalancing is a meaningful source of return which not only helps mitigate drawdowns but it also adds to compounded growth over time. Then the third thing that we know works in investing is keeping your costs down. So the main drag on the portfolio is taxes for

[00:21:33] individual investors. So we think about what can we do to help manage that impact and taxes, of course, are inevitable but you can take steps to minimize it and reduce it and maybe even avoid

[00:21:46] triggering taxable gains altogether. So we put fairings in a sense in the portfolio where we're trying to deflect short-term capital losses into the recognized category and put gains into a deferred category. So if we can accelerate capital losses while deferring gains, we can actually

[00:22:07] in many cases create a tax benefit where if you can use those losses elsewhere in the portfolio then again it helps avoid that erosion of capital that comes from taxes.

[00:22:19] So the way that we think about using this strategy, it's less about how it works in isolation. It's more about what effect does it have on the portfolio at large? Like what does it allow us to do?

[00:22:32] And the way we think about it is it allows us to have a portfolio with what we think is real diversification. It allows us to have a rebalancing strategy that we can implement by responding to change. We're not needing to anticipate changes, we just respond to what the

[00:22:49] market presents and it also provides us with opportunities to be smart about taxes. I want to actually spend some more time on the tax side because of the 150-odd podcasts that I've done, we've almost never talked about taxes and as you suggest it's there for the taking

[00:23:10] in terms of trying to be thoughtful around managing it and so it's almost an afterthought but there's real value to be had in being strategic about it. But before we do that I wanted to talk a

[00:23:21] little bit more about just conceptually the behavior of the portfolio and the portfolio's interaction with its hedges in down markets. There's a long body of research in the derivative space about this thing they call the vol risk premium. The insurance seller got to make money too.

[00:23:43] So the behavior of an index like the S&P 500, its realized volatility is outstripped mostly 80-odd percent of the time by the implied volatility. That's the premium of implied to realize people call that the VRP and over time you're going to make money if you're providing

[00:24:01] that insurance and if you're always buying that insurance there's going to be a drag in the portfolio. I think what a lot of these research pieces miss even though they're academically rigorous,

[00:24:13] they miss this idea of how you react to a down market and this notion of being a buyer of newly cheapened assets in down markets and the hedge providing some runway to do that.

[00:24:28] I'd love for you to just talk a little bit about how you think about redeploying or deploying new or fresh capital into down markets with the use of these hedges. I couldn't agree with your comments more. You're exactly right that hedging involves

[00:24:44] kind of buying an option-based insurance and insurance isn't free so there is a cost to owning options and we expect the long-term return of most hedging strategies to be negative and of course academic papers or even conventionalism says well you shouldn't use this strategy because

[00:25:03] why would you own a money losing strategy that will only detract from your returns and really at some level I don't disagree. We actually underwrite our own sub-advisors strategy with the assumption that there'll be zero expected return but like you said you have to

[00:25:20] consider the bigger picture as well so we don't use this strategy in isolation. We use it in combination with other assets so you have to ask the question what effect does this derivative strategy have on

[00:25:38] the portfolio in aggregate and if that strategy, if the derivative overly strategy is actually negatively correlated with equities, meaning the gains happen when there's equity drawdowns and if those overlay losses aren't proportional to gains so if you have some convexity there,

[00:25:57] meaning the overlay makes a little more on the downside than it loses on the upside, then pairing that strategy with equities can actually cause that portfolio to make more money over time even if that overlay strategy is actually losing money in isolation and we see this because

[00:26:17] of well a couple of factors but one is the rebalancing bonus so again we're regularly rebalancing opposing assets. These gains from the overlay happen when the markets are down and to your point if you're getting liquidity as the liquidity premium is expanding that's an

[00:26:37] opportune time to be buying equities so we end up buying more shares when equity markets are down and then the way the math works if a market say is trading at 80 cents then our dollar of capital

[00:26:49] is going to buy 1.25 shares and then if the equity markets go up and save from 80 cents to $1.20 well we expect to have some losses from the derivative overlay because losses happen when

[00:27:03] equities are up we can sell that and raise a dollar of capital by selling 0.83 shares and so on a net basis we've just accumulated more shares for the portfolio just by rebalancing these opposing

[00:27:17] assets and I guess the way we think about it is it's the paradox of having a good defense so a good defense yes it limits loss on the downside we have gains when markets are going

[00:27:31] down but it also like sets up the offense and it sets it up in a good position and you actually have cash right at the time when it's advantageous to be taking another shot so I think that bigger picture

[00:27:45] of how it works with equities is what makes it so powerful so the bleed certainly matters but I think it's offset with the rebalancing bonus and then I'd say it actually goes even a

[00:27:57] little bit deeper than that and I know we haven't talked about taxes yet we probably will but let me just say that that overlay strategy also has a way of turbocharging our tax loss harvesting efforts too

[00:28:10] so it's not only the rebalancing but it's also promoting tax efficiency along the way which is yet another kind of source of value so to be honest if that overlay strategy was to have an

[00:28:24] expected negative return over time I would say it's still well worth holding it because of what it allows us to do with rebalancing and through tax loss harvesting yeah insurance is effective the price

[00:28:39] obviously matters you know I always go back to you're at the checkout line at Best Buy and you've bought a $60 alarm clock and they're trying to sell you on the insurance out five years

[00:28:51] and it's $10 a year right so of course the price really matters all right so let's talk a little bit about taxes so you've got a couple of different components to the product that you're

[00:29:04] delivering to your end investors one of which is beta and you've got beta that really very closely tracks the S&P as I understand it but you've chosen to use individual securities

[00:29:18] and I think that there's some tie into tax goals there I'd love for you to talk about that a little bit so tax loss harvesting as a strategy is nothing really new it's been widely used I was using it

[00:29:33] back in the Quello stage you know it's 20 some years ago we had clients who are using the strategy but it was mostly used in the context of long only investing and the idea is you want

[00:29:45] to have a beta exposure let's say S&P 500 and instead of buying an ETF SPY or below instead of doing that own a basket of individual stocks that are representative of the index and by owning

[00:30:04] the individual securities and you own these through a separately managed account so think of it as a brokerage account at Charles Schwab or wherever it gives you the ability to have a lot more control

[00:30:16] over the timing of your capital gains and losses and if you can selectively excel at recognition of capital losses so you're here when I don't know Disney runs into trouble and then if stock is

[00:30:30] down x percent well maybe you might sell Disney and buy Warner Brothers something similar but in that process of exchanging a security that has gone down you can recognize the capital loss while still preserving the overall exposure that you want of exposure to that media sector

[00:30:48] and then on the other side of the equation is if you can defer gains among those hundreds of individual tax lots in a portfolio then you can help minimize and defer your tax liabilities

[00:31:01] so this strategy it's pretty effective there's a couple of knocks against it first of all most direct indexing managers they don't really want to have to deal with the wash sale restrictions

[00:31:15] so if you sell a stock you can't buy it back within 30 days otherwise your capital loss is considered a wash sale and you're not allowed to take it during that tax year so what most direct indexing

[00:31:25] managers do will trade a portfolio and then just set it aside so wait 31 days for the wash sale window restriction to clear and then they'll revisit it again so at most if you are directly

[00:31:38] indexing a portfolio with a long only manager they're probably going to touch your portfolio no more than call it 10 or 12 times a year so it's an actively managed strategy but within quite a few

[00:31:52] limits and then the second issue and this is the bigger issue is that the long only portfolios tend to become what you'd say ossified over time so equity markets tend to appreciate so the holdings

[00:32:07] that you have tend to develop embedded gains which obviously limits your ability to harvest losses in the future and it also limits your ability to rebalance the portfolio without recognizing significant taxable income so the way these strategies work is the tax loss harvesting

[00:32:27] it tends to be pretty good in the first few years and then it tends to fade away as equity markets rise over time and what you're left with is investors are kind of frozen in these portfolios

[00:32:39] of individual stocks that mostly mirror an index but they have a hard time rebalancing because of the embedded gains so we use a little different portfolio structure ours is long and short and so

[00:32:53] we do use long only direct indexing for our long beta exposure there's certainly merit to having that control over hundreds of individual tax slots and then we pair that long exposure with a short exposure through the overlay and now this becomes interesting because those overlay

[00:33:12] losses again because it's inversely correlated with equities they tend to happen during market upswings so we have two sides of the portfolio one tends to create the potential to harvest losses in down markets which is our long side and then the other tends to create this potential

[00:33:28] to harvest losses in up markets and by having both sides of the equation there it creates more of a persistence to our ability to harvest losses and kind of minimize that ossification issue

[00:33:42] that tends to happen and to be honest like the last what's it been 15 months or so since beginning of 23 when S&P's up call it 30-ish percent I think if you talk to a long only direct indexing manager

[00:33:55] they'd probably tell you that their loss harvesting efforts have been pretty tough but I'll say it's actually been a pretty good environment for us it's been losses we've been able to harvest on the short side and preserve those capital losses both the way we rebalance on the equities

[00:34:12] and then one other element that's probably worth mentioning is that we regularly rebalance portfolio risk again as the gamma strategy were regularly in there adjusting the portfolio and another side effect of that is that it tends to create many many individual tax slots over the course of the

[00:34:31] 252 trading days in a year so we might hold call it 200 names out of the 500 names of the index but we might have well over double that number of individual tax slots so you end up with this

[00:34:46] dispersion of tax strikes based on when we purchase the stock some will be close to the money some further away and that dispersion also helps just preserve flexibility for making portfolio adjustments down the road with limited tax implications so we're not tax advisors clients

[00:35:06] need to talk to their own CPAs but I'd say just understanding the implications and setting up a structure that allows you to kind of benefit from up markets and down markets is a way to

[00:35:19] potentially create this more evergreen approach to loss harvesting and again we all know the benefit of saving taxes as a way to kind of keep principal in your portfolio. Well you said up markets and down markets so let's zero in on two years that were really

[00:35:36] mirror images of each other so 2022 and then the bear market of 2022 and then something rip roaring back in 2023. 2022 was fascinating because the S&P lost almost 20% but a lot of the standard hedging strategies really just failed to work so I would just want to read

[00:35:58] some quick stats for you and then we can talk about what you guys did which was very successful in 2022 so I said S&P down almost 20 there's a PPUT index PPUT which is just S&P plus a 5% out of the

[00:36:13] money one month put that gets rolled on a monthly basis also lost 20% so no benefit to owning the put. There's a put spread collar index so the CBOE puts out all these great indices

[00:36:26] that are some version of an overlay on top of the S&P so the put spread collar index long a put spread and short an upside call that lost 13%. The buy right index the BXM it's been around for years that

[00:36:39] lost 11% and then another interesting one I thought was worth mentioning is this RXM so it's a risk reversal index it sells a 25 delta put and buys a 25 delta call so it's long 50 delta

[00:36:55] that actually gained 1.5% so a real all over the map just in terms of whether you hedged how you hedged the way in which you implemented it and I know Smithbrook had a lot of success in 2022 so

[00:37:10] I'd love to just have you run through that some portion of it as you were just walking through was thoughtfulness on the tax front I found that really interesting so tell us about 2022

[00:37:22] from your standpoint how you approached it and how you were successful on behalf of your clients. Yeah so let me lift one saying from convexitas the way they describe their approach it's risk over rules and I think that's actually one of the probably the bigger differentiators there among

[00:37:40] those different reference points you mentioned I imagine many of those are somewhat systematic in nature in terms of what the role strategy is and I'd say the systematic approaches well first of all coming from the wealth advisory family office world they're easy to explain I could

[00:37:59] explain that to other members our investment committee or the clients and people get it and so like it's easy but it's not without their drawbacks and I think one of the biggest drawbacks

[00:38:09] of a more systematic approach is that relying on the calendar or some sort of premium target to define the role strategy is that you are introducing a timing risk. March of 2020 is probably the best

[00:38:23] example of that where if you happen to catch that dip in March of 2020 and really your puts then then you look like a hero but if you were just a couple weeks late with the calendar then

[00:38:34] you were unlucky we don't take a systematic approach in terms of relying on the calendar or relying on some sort of premium spend figure instead the driver is the risk profile of the

[00:38:48] portfolio and so again we're long beta long overlay and then we do manage the tax consequences for the overlay side of it the home base position would be to be say short 20 deltas and be long

[00:39:02] camo if the market's moving down like in 2022 and your deltas moving higher well that's the queue to be resetting the position lower and monetizing it and so 2022 was actually a really I guess target rich environment for capturing gains through that down market the target profile or the

[00:39:24] target return that we're looking for from that strategy is about half of the loss of equities over time and that's about what the overlay produced for us in 2022 so market was down

[00:39:37] 18 and the overlay was up call it nine then this sort of idea of tax loss harvesting well there's a certain asymmetry to that as well because boy I might take us a little bit into

[00:39:50] the weeds here but the character of the taxable income matters and the option strategies because they're options on futures those are characterized as section 1256 income and section 1256 income has a tax rate that's a blend of 60% long term and 40% short term

[00:40:12] so let's just say for round numbers is call it a 30% tax rate well that's useful because on the equity side of the portfolio we tend to have two different sorts of characters of

[00:40:25] income one we could have short term capital gains or losses and let's just say that's a 40% tax rate or we could have long term capital gains or losses and that gets an advantageous rate of call it 23

[00:40:37] or 24% what that allows us to do if we can do this again first of all it's about managing the risk in the portfolio but if we have the opportunity when the equity markets are moving

[00:40:50] down like a period like 2022 we will try to accelerate short term capital losses at a 40% tax rate is the benefit there and that's offsetting the gains that we see at 1256 levels which is a

[00:41:05] lower tax bracket so not only are we kind of finding ways to harvest losses in a down market as equities move down but we're able to do it in a way where we're maximizing the capital

[00:41:18] losses that we can harvest simply by prioritizing a certain character of the income so 2022 it was a good year we were able to capture 7 ish percent of the portfolio value in the form of capital

[00:41:33] losses which could be used to get offset gains elsewhere it won't always be that good of an environment but it was probably about the most target rich environment that we were able to

[00:41:44] experience so far and so back to my little best buy example about insurance you know insurance is good for a peaceful night's sleep but of course when things go well for an extended period of time

[00:41:56] people start to wonder about overspending on insurance and so as we think about 2023 as the market came rip roaring back the S&Ps up these are just price changes not total return but

[00:42:09] the S&Ps up 24% and something like the BXM the buy-riding index is only up half of that at 12% how do you think about the kind of potential for give back in markets that recover and sometimes

[00:42:23] recover forcefully? Yeah so our objective is to grow capital over time so we want to capture that give back we want to capture the up markets so I know a lot of the systematic strategies

[00:42:37] will tend to do things like sell an upside call to fund the downside put spread we don't do that we don't sell upside calls we want the beta and then we want to have an overlay strategy that's

[00:42:49] asymmetric in nature so when equity markets are moving up we want that exposure to fade away and leave us just longer stock and so the design is probably the first way to approach it where

[00:43:03] don't sell the upside keep the upside and then to have an overlay that was positioned anyway to fade away and allow you to capture the bigger up moves so the convexity is important and then the other

[00:43:17] element of it is to again use the tax code and the way that that works well in an up market we tend to generate losses on the overlaid side again call it a 30% tax rate if we can fund those

[00:43:34] losses we need to sell a little bit of stock so first of all we'll see if we can harvest any losses on the stock side if we can grade if we can't then the next thing we might look to are long-term

[00:43:45] capital gains which have a 23-24% tax rate and then lastly we would look towards recognizing short-term capital gains so 2023 is the example I guess where we generated tax losses or capital

[00:43:59] losses at the same time that we captured a large percentage of the equity move or the equity rebound so if we can capture 80% of the S&P on the upside and offset half of the losses on the downside

[00:44:15] that sort of profile is one where I think it sets us up pretty well to compound capital over time and structurally I think we've kind of tried to position ourselves to be able to do that through

[00:44:30] this combination of being long beta, long an asymmetric overlay strategy and then being smart about the taxes. We live in this world of vast technological change some of it's pretty exciting sometimes maybe it's a little scary but NVIDIA perhaps is the poster child of some of this

[00:44:50] change and of course it's just been an absolute juggernaut of a stock and has just become a larger and larger portion of both the QQQ and the S&P. How does that kind of top heaviness of an index

[00:45:04] like the S&P 500 and some of the just vast outperformance of stocks like NVIDIA, how does that impact your work on the tax front and the tax harvesting front? Yeah it's interesting I mean the index has become quite concentrated and obviously names like NVIDIA or the other MAG7

[00:45:25] that have moved up so significantly first of all from a risk standpoint we want to keep our expo order to be similar to the index and so position sizes grow with the index and at the same

[00:45:40] time the embedded gains have been growing in those positions it does become more difficult to rebalance out of those if we needed to like for example if the position size had grown disproportionately large to the index if you're in a long only strategy it becomes really hard to

[00:45:59] rebalance out of that because now you're looking at well maybe you're in a 400% gain position or something like that and you need to trigger that gain and just in order to get your risk back to

[00:46:09] where you were. In our portfolios we have a little bit more flexibility because we're recognizing capital losses we tend to recognize capital losses from the short side of the portfolio so

[00:46:22] this gives us an ability to manage that risk if we have some lots in NVIDIA that are in long-term capital gains position we can strategically recognize those gains offset by losses elsewhere

[00:46:35] in the portfolio and allow us to get the portfolio risk back to where we want it without incurring a tax consequence to do so. So we don't take a view on the index itself some things are kind of

[00:46:50] hard for me to understand why they're valued as they're valued but I'll leave that decision up to other people what we want to do from a risk standpoint is to closely match our long beta with

[00:47:01] our short exposure which is also through S&P and then if we need to adjust the portfolio because one position or another has grown overweight we try to preserve the flexibility to do so with triggering as limited tax consequences as possible by kind of using the full extent

[00:47:18] of the portfolio if there's losses elsewhere we can use to do that then we will. Well last topic I just wanted to get you to reflect on a little bit is just the

[00:47:28] industry at large of let's just call it risk managed equity I don't know if that's a great term for it but Mandy Zoo who is the head of derivatives market intelligence at the CBOE

[00:47:42] was a recent guest and that podcast is coming out next week and one of her charts shows that it's now 120 billion dollars of aggregate AUM across ETFs and mutual funds what about 50-50

[00:47:56] that in some ways sell options for premium we've got this perhaps consistent with society at large this instant gratification of the one day option or the zero DTE option so these markets are kind

[00:48:10] of changing in character in some ways but I'd love for you to just talk out loud about where you see perhaps the Smithbrook product going what your aspirations are and just the broad question of

[00:48:22] using optionality in the portfolio I'd love for you to just reflect on that a little bit. When you mention that it just makes me think about how there's a problem with the money

[00:48:33] at root I think that all of us all individuals and even institutions we're all kind of facing a similar problem in that we're working and putting in our time and energy and skill to try

[00:48:46] to provide values to others and then we accept dollars in exchange for our work and those dollars are great at exchanging value across space like you can spend your dollars today just about

[00:48:59] anywhere in the world of a grocery store or vacation or new car or whatever but those dollars are terrible at exchanging value across time so dollars leak value at say five to seven percent compounded per annum so individuals have a real problem right we earn money now we

[00:49:20] want to use it in the future how do we transfer value across time and there's many strategies to try to solve that problem maybe zero day options are part of one of those strategies but I'd say the entire wealth management industry really exists simply because

[00:49:36] dollars are not a suitable for transferring value across time and so most people well derivative strategies like the zero day options are maybe one answer but I think most individual investors or family office investors tend to lean on ideas like building

[00:49:55] a diversified portfolio you'll hold some cash and bonds and stocks and real estate and private equity and hedge funds all the rest of it and by having this mix of holdings of assets paper assets productive assets scarce assets this group of holdings will outperform the money

[00:50:15] dilution rate is kind of the assumption there but the big assumption is that there will be low correlation among these different assets and Dean I think I've heard you say before there's no bad prices only bad correlations and I think that's right right because in stress periods the

[00:50:34] correlations always move towards one and so I think there's an argument that this more traditional approach to diversification isn't exactly what it used to be in a world which it's a debt driven world where all risk assets really seem to kind of follow the capital flows

[00:50:53] or the voice of the Fed and I wonder sometimes whether or not like owning a basket of large caps small cap stocks and private equity real estate all the rest of it if it really

[00:51:05] will behave differently from one another in kind of a fundamental way and we have jokingly say what you're getting with that is really just a can of soup and what I mean by that is

[00:51:18] in the 70s when I was growing up then you could buy a 10 ounce can of Campbell's tomato soup for 10 cents and just last week I was on spring break with my kids and we were at a resort and so

[00:51:30] the resort pricing is obviously a little bit more ahead of the rest of us but there was a can of tomato soup at the store and it was $3.15 so that's a 31.5x return on a can of Campbell's

[00:51:44] tomato soup over just over 50 years and so that's a 6.7% compounded annual growth rate and I wonder how different that is from owning kind of a well diversified investment portfolio so this is the problem that I think people are trying to solve is how do you invest capital

[00:52:06] in a way that gives you some likelihood of exceeding this money dilution rate and maybe it's pushing people to do things that have seen kind of crazy but I think that derivative strategies can be part

[00:52:18] of the solution in that they can provide I'd say two obvious benefits and the first which we've already kind of talked about it's that potential to improve portfolio diversification so instead of relying on this assumption that these different assets are going to behave

[00:52:36] differently from one another eliminate that assumption you know just diversify it directly match your betas like own S&P and own short S&P you have these contrasting strategies that are linked to one another and take away the hope for low correlation that's a very powerful feature

[00:52:55] if you can have assets that are actually negatively correlated and I think equity derivative strategies are like a very precise tool that can allow you to do that and then secondly the thing that

[00:53:06] the derivative strategies can be helpful with is the potential to improve the liquidity profile so a lot of investors tend to lean on private assets have your private equity and private debt and real estate holdings and even more limited liquidity assets like hedge funds and this can be

[00:53:27] good you know certainly there's tends to be a premium for locking up your capital but does that really compensate you for the cost which is by tying up your capital you're eliminating or reducing your ability to rebalance the portfolio so in a sense you're giving up

[00:53:45] the rebalancing bonus that you can get simply by having cash available with the markets kind of chopping around so I think that derivative strategies kind of smartly employed have a real potential to kind of help solve this savings problem that we're all facing simply by helping improve the

[00:54:07] portfolio construction for handling the environment that we're in so that's kind of how we view it we don't get involved in kind of speculating in zero days and the like we try to use it in a more

[00:54:19] precise way to solve for the portfolio construction objectives that we have. Yeah I think the intellectually honest answer around derivatives especially things like the S&P 500 complex it's deep it's liquid there's not a lot of free money falling out of trees when it comes to the S&P

[00:54:37] options market but that being said to be able to shape the distribution of outcomes whether it's mitigating downside in exchange for perhaps giving away some of the upside if that tradeoff can be done

[00:54:51] carefully and thoughtfully you can reduce the overall risk of the portfolio and I think what it does is it allows people to stay in the boat longer I think that's the big risk they say

[00:55:04] it's not timing the market it's time in the market right so that's how you compound over time and of course limiting those drawdowns is the big part of what folks like you are up to. So Jerry this has

[00:55:15] been great I learned a lot about some of the in the weeds on some tax harvesting strategies and I thought the discussion was great so thanks so much for being a guest on the Alpha Exchange.

[00:55:27] Yeah thank you Dean I appreciate the conversation with you it's nice to be speaking with somebody who understands these issues so deeply so I appreciate the conversation. Fantastic. The discussions and information presented in this podcast are for educational

[00:55:42] and informational purposes only and do not constitute investment advice or an endorsement of any specific investment strategy or product. The strategies and examples discussed are meant to be illustrative not personalized recommendations all investments carry risks and the systems

[00:55:57] and strategies covered are subject to ongoing evaluation and change. We strongly advise listeners to consult with a qualified financial advisor who can provide advice tailored to their individual financial situation and goals. Additionally as tax laws and personal circumstances vary

[00:56:13] we urge you to seek guidance from a qualified tax professional before making any decisions that could impact your tax liability. You've been listening to the Alpha Exchange if you've enjoyed the show please do tell a friend and before we leave I wanted to invite you to drop

[00:56:28] us some feedback as we aim to utilize these conversations to contribute to the investment community's understanding of risk your input is valuable and provides direction on where we should focus. Please email us at feedback at alphaexchangepodcast.com thanks again and catch you next time