Wealth Management Invest: Unpacking Autocallable ETFs with Matt Kaufman

Speaker A: Are you a Series 7 licensed financial professional looking for more out of your career, like a stable environment where you'll get the support and resources you need to do your best work and focus on the client? Fidelity is currently hiring remotely and in our branches. Join a financial services leader that cares

Speaker B: about the people on both ends of

Speaker A: the call, the client and the employee. Visit series7.fidelitycareers.com and explore opportunities. Today, Fidelity is an equal opportunity employer.

Speaker C: Foreign.

Speaker B: Welcome back to the Wealth Management Invest podcast. I'm your host, David Bodimer, Editorial Director, Wealth Management. Uh, happy to have another exciting conversation. I'm really excited to catch up with someone I've spoken to many times over the years, both at, you know, conferences for stories, uh, but excited to really talk about this innovative product that they've brought into the market over the past year. So I, you know, so I'm going to let him introduce himself a little bit and tell, tell us about his firm, but it's Matt Kaufman, global head of ETFs at Calamos. Matt, great to catch up with you again.

Speaker D: Hey David, thanks for having me. Good to be here.

Speaker B: So, as I said, um, why don't you just, you know, give the audience for folks who may not be familiar, just a little bit about yourself and a little bit about Calamos.

Speaker D: Oh, sure. Appreciate that. Yeah. So I personally been in the ETF industry for about 23 years. I started my career at PowerShares building out the smart beta ETF space. After PowerShares sold to INV, I went to an actuarial consulting firm, which, you know, makes about as much sense to me saying it out loud today as it did doing it back then. Um, the goal was to take all of the risk management strategies we were running on the balance sheets of large life insurance carriers and build funds out of them. And then you could offer higher guarantees on your variable annuities. Uh, you could do a lot with fixed indexed annuities and registered indexed annuities, or structured annuities as they became known. So we did a lot of work on that side. That's where, excuse me, that's where I built out the intellectual property for the buffered ETF space. Uh, so that was in about 2016. We saw this rise of structured annuities in a zero rate environment. You know, it was very difficult to provide much value when interest rates weren't giving you much, uh, to buy optionality with. And so a lot of insurance carriers and banks move toward what we would call a risk sharing model. Uh, instead of principal Protection, you could do something less like a 10, 20% buffer and then give somebody meaningful upside relative to that protection level. So we noticed that you could do that way more efficiently with options. Uh, you did not need a balance sheet to deliver that type of exposure. And so we built out the buffered space. We gave that to an ETF provider. You did it in UITs, in insurance products. And you know, that space has grown tremendously. Well, the idea of a buffered fund is now a very household name. You know, it's been 10 years since that first came to market. So now we're seeing the evolution of the space. You know, we can actually work with banks, work with their balance sheets. Interest rates are not at zero anymore. And so we were able to bring, uh, you know, additionally the world's first auto callable ETFs to market, which I think is the focus of this. So that's something that's been really revolutionary in the space. There is a remarkable income revolution happening, especially in ETFs and, and particularly with options. And so I think we can spend the next 20 minutes diving into all that.

Speaker B: Yeah, thank you so much for setting that scene. Uh, if folks are, if anybody is familiar with Calmos, they've certainly gotta be familiar with your buffer, just your defined outcome suite, your buffer suite, the stuff that you've done on crypto.

Speaker D: Sorry to interrupt you. I left that out. So I'll give you the Calamos overview, the 30 second pitch there.

Speaker B: Sure.

Speaker D: So Calamos has been around for 50 years. We were formed just a few years after the options markets opened in Chicago. So 73 the options opened. 77 Calamos was formed and we've been doing alts and options based strategies since that day. You might know Calamos for convertible bonds. We are the largest manager of converts in the United States, second largest globally. And what you'll find out hopefully by the end here is an auto callable is a lot like a reverse convertible. So it's an instrument that Calamos has been using for a very long time. But we're very large alts manager. Uh, we run the market Neutral Income Fund, which is I think the second or third largest liquid alts fund in the country. About 17, $18 billion in size there. So, uh, yeah, good overview of Calamos.

Speaker B: So as you alluded to, what I did want to get really dig into here with this conversation today is the auto callables ETFs that you guys have brought to market. I believe the first one is probably right around A year old at this point you've got at least three varieties for the US market. You've now introduced the product into international as well. But like let's, before we get into some of the, some of the flavors that you're, that you're innovating and iterating on, let's just start with the basics of what is an auto callable. It's my understanding is it's kind of a, a market linked investment which offers some regular coupon and, and a principle over a time period contingent on the performance of the underlying index on which you're basing this. So and, and there's a big market that this has existed. It's not a, it's not a new thing. It's autocallables have been around is new is, is delivering it in this ETF wrapper. So take what I just said, uh, offer any correction.

Speaker D: I think you nailed it.

Speaker B: If I got anything wrong or how, you know, just like digging, digging a little deeper on what I just said.

Speaker D: Yeah, I think we can take this in maybe three phases and talk about the derivative income landscape. Uh, we'll do a primer for autocallables and then we can talk about the Calamos approach and why doing it in an ETF wrapper can add a whole host of efficiencies and tax efficiency, liquidity, transparency, reduced counterparty risk. We can hit on all of that.

Speaker B: Cool.

Speaker D: We are witnessing a revolution, I might say, in how investors think about income. You know, if you look at the derivative income landscape just across ETFs, I was fortunate to have built the first Buyright ETF in 2007. It was a PowerShares ETF. Not many people bought it back then. The market crashed a few months later. And then I think people had other things to worry about than, you know, their buy right strategies. But fast forward 20 years and that covered call space. The derivative income ETF landscape is hundreds of billions of dollars. I think it's approaching 300 billion if we haven't already passed that. So people are looking for differentiated sources of income. Historically, you know, you would use traditional sources like bonds and those would be used for income purposes and risk management purposes. I think we entered into an arena where we can now bifurcate those two. We can look to the equity markets to deliver risk management. We can use the equity markets to deliver income as well. The covered call is a very popular way to do that. If you go to the structured note world. Derivative income dominates the structured note world as well. But it's done so through a strategy known as the auto callable yield note. And it's a, uh, strategy that's relegated to structured notes because it's hard to do an auto call feature in terms of an option that just can't be done in the listed markets. So this is about $100 billion per year space. It's growing very fast in the United States and it's multiples of that globally. Europe and Asia is actually ahead of the US in terms of its adoption and understanding of auto callables. So uh, that sets the stage. You know, we're in this environment where a lot of financial advisors use auto callable yield notes to generate above average income levels and like you said, to tie their income to an equity linked instrument. So maybe a simple way to think about an auto callable is to think of it like a bond whose income and principal value depend on the stock market not falling too far. So that's different than a traditional bond where you might be tied to factors like credit risk or credit quality, interest rates, duration. Here it's like a bond that's tied to the equity markets so you're going to get paid regular coupons as long as the underlying index you're tied to does not fall below a set threshold or what's known as a barrier. And then there's a maturity feature as well where your principal is going to be returned to you at maturity or if called early as the name implies, auto callable. And you're going to get par back as long as you don't mature below that principal threshold as well. So if you just tied it to an index like let's say the S&P 500, we can give you an example. Uh, one thing that we did with our team here was we used Monopoly money and that seemed to go over well. So you know, David, if we just, you know, pretend like you give me $100, we can set that aside, that's your par value. And then let's say that we tie that $100 to a uh, five year note that has a monthly observation and then um, a barrier, a monthly barrier of minus 30% and then a principal barrier again of let's say minus 30%. So what that means is that every month we're going to look at this note that you've purchased. If the reference index, if the S and P is down by 31 month in, uh, you're not going to get paid, but the odds of that are very low. So let's say the market's up at One month in, you're going to get paid. So if we say this has a 12% income, you know, a dollar a month for ease of illustration. So if the S and P is up, you're going to get a dollar that month. For the next month, the S and P is down, let's say 20 since inception. You still get your dollar because you're not below the threshold. And then the third month, let's say the S&P falls by 35 since inception of that note. Well now your dollar turns off no dollar for you that month. And then in the fourth month, if the reference index appreciates, let's say it goes up to minus 29% just above the threshold, you're going to start getting paid again. And so that's how we uh, deliver uh, this really high and consistent income, um, because it's tied to a deep barrier that is rarely breached. And then as long as, uh, you don't mature at the end of the fifth year, down by 30, you're going to mature a par. The odds are you get called away. Most notes have a auto call feature. After one year. The average life of one of these notes is about one and a half years. The odds of you actually making it to the fifth year are remarkably low. But if you do, then that means that the reference index can go down by up to 30% and you'll still get par back on that $100. So that's how an individual note works.

Speaker B: And that barrier that you talked about, is that 30%, is that what you're actually using on your exact.

Speaker D: So that's an example of an individual auto callable yield note with 30% downside barriers. We have two income products in the market. So we launched last June, we launched caie, which is the Calamos, uh, Auto Callable Income etf. It was the first one in the market. We're approaching a billion dollars in assets in that, that particular fund. About a year track record, I think in a few days here. So that product is working remarkably well. The way that we build that is it has minus 40 coupon barriers and then a minus 40% principal maturity barrier. So it's a five year, uh, laddered portfolio of five year notes. So I gave you an example of a single note. So what's the risk of a single note? Well, it would be that the market's down by 40 at the end of the fifth year. Because if that's the case, then you would have just lost 40% of your principal. That's not something anybody wants to be a part of. Well, if you ladder that out 52 or more times, where every week you're writing a new note into the portfolio, we can now give you a remarkably diversified experience where if at the end of the fifth year, that'd be a pretty bad market environment. Well, if the reference index is down by 40 or 50%. Well now, uh, you've only lost 50% on 1 52nd of your portfolio. So you have remarkable diversification by doing this inside of an ETF wrapper and laddering it all out. So that's a large reason that we did this inside of the ETF wrapper, was to give people remarkable diversification. You know, from a business development perspective in any industry, uh, a lot of people will say, you know, go solve a problem for somebody, find a gap in the market and, and fix that gap. Well, what we were seeing, having been in the options and note space for a long time, we saw a lot of advisors using individual auto callable yield notes. They would get called away after six to 12 months. They'd have to go find a new note. It was very burdensome for them. The terms of the notes would, would generally change on them with market parameters. And so they were looking for a solution like this. So we were able to build an ETF version and then reach back out to those advisors, you, uh, know, give you an anecdote. We had one advisor out west who said, I, every month I fly to New York, I look for, um, you know, different notes. I meet with all the banks, try to find the best ones. And he said, I canceled my flights because this makes things very efficient for me. It's a standardized term for each of the notes inside the portfolio. And so it is creating a lot of operational efficiency for advisors who already use yield notes, and then, you know, for those who don't. For those who might be familiar with covered calls, you know, the covered call can give you a decent income, but you are tied to, uh, things in the options model. You're tied to interest rates, you're tied to volatility, you're tied to dividends. And so if volume is high, when you write that option, you collect a high income payment that month. If all is low the next month, then what happens to your income? It goes down. And so we have worked to solve for a lot of these problems, but with the covered call, one of the biggest things that people complain about is, uh, nav decay. And that's what happens if the market goes down. Well, now you have to sell off all of your upside you're writing a covered call after the market has gone down and you're really handicapping your ability to recover. And so that tends to create this nav decay over time. You know, there's been some attempts to solve that. Some shops will try to choose stocks that you know, tend to be more defensive in down markets. It's an actively managed approach. Some will sell out of the money calls in order to get a little bit of uh, upside and sacrifice some income for that. Well think about our earlier comment about these being like bonds that will be called away or mature at par. You eliminate the nav decay by having bonds be called away or mature at par through the auto callable yield note. So it's a way for us to deliver equity linked income and have those bonds or those auto callable notes snapping back to par over time. And so you can eliminate that nav decay that are traditionally associated with covered calls through the auto call. And so you know, if you're not familiar with auto callable yield notes, but you are familiar with covered calls, you can anchor to that. This is a lot like a long dated put writing strategy where all of your notes will mature at par outside of, you know, maybe the worst case scenario right M. You know, which we can walk through some of that too.

Speaker B: So a couple of thoughts. One is just in terms of, of proof of concept and, and, and proof of the market interest. It does stand out to me that, that you're the primary, the first one you launched has reached almost a billion within a year. And then that you've iterated and, and those are amassing assets at a pretty rapid clip. So that seems like a pretty strong endorsement of what you're doing. The second thing that I noticed that I feel like is a strong endorsement is the fact that now you see other asset managers jumping on this auto callable train and, and, and, and trying to follow, you know, ride on your coattails and, or you know, just also get in on this. So it does seem like there's there are, there, there are real, you know, you are solving a problem and, and really gaining some traction with this.

Speaker D: Yeah, there's a couple things that, that we solved with the first auto callable etf. I, I've really never seen a category copied so quickly. I don't know if that's a um, you know, sign of maybe the regulatory environment that we're in or just the fact that ETFs are explod but you know, we didn't see the buffers copied this fast that took you know, a few years for a number of players to come into market. And here we've got several players building auto callable income type products. I can tell you that we spent about two years mapping these out and finding what we think is the best way to deliver auto callable income. The goal for our initial two products for CAI C A I E and C A IQ which is uh, on a NASDAQ 100 framework, is to deliver high, stable and tax efficient income. Like those are our three core tenants. Everything that we've done in the portfolio in the product is to serve those three tenants high stable and tax efficient income. So we've looked at a lot of other structures we've looked at, worst of which is a different type of auto callable single stock auto calls. Uh, doing the approach that we have taken in my view is the best way to deliver high stable and tax efficient income. So uh, you know, think about our covered call discussion where you're at the mercy of market volatility of dividends, of interest rates. Well, what if you could stabilize volatility in your options pricing model? Or what if you could stabilize dividends in the options pricing model? Those are things you cannot do in the listed space, but you can absolutely do that in the non listed space. And so that's the approach that we've taken with CA. We've stabilized the volatility of the S&P 500 or the NASDAQ 100 around a, uh, high target. Volume. Target volatility has been around for a long time. Insurance carriers have been doing this for decades to stabilize the volatility in their balance sheets. We are stabilized around a high level, which means every week when a new note is written in the portfolio, we collect a high income. And that's a very stable and high income as well. And then there's also a synthetic dividend that we overlay as well. It's called a decrement. And that is a way to stabilize the dividend performance inside of the reference index as well. So there's a lot of uh, you know, pieces of the watch gears that are all working together to make that time really efficient and make it really stable. And so every month you're getting this high stable and tax efficient income inside the portfolio. And then the way that we distribute the income is that it's nearly all of it is treated uh, as tax deferred income. And then if you hold for longer than one year, you will pay long term capital gains on the difference in the income in the cost basis that you've received. So no more ordinary income like a traditional bond, no more 60, 40 which you might be able to get through index options. We are able to distribute a majority of this as return of capital. Uh, that's constructive return of capital. Don't be mistaken. This is not just us returning your principal to you. That would be bad. We are not doing it that way. This is treated as return of capital, which means it's tax deferred and then you'll pay long term gains if you sell after one year. To give you another example, we have some advisors who plan to, you know, never sell for the life of their client. You know, maybe you don't need 14 from CAIE or close to 18% from CAIQ. Maybe you need 4 to 6% as your retirement, uh, you know, your retirement income vehicle. Well, if you're just taking that and reinvesting the difference now, you can create a cost basis that will, you know, in theory last 20, 30 years. And then you can bequest those shares to your heirs who will get a step up in the basis. And you've largely created tax free income for that retiree. So there's a lot of very interesting, uh, ways to use this.

Speaker B: Yeah, that was going to be my next question, which is just as you've seen advisors allocate to this, what part, you know, like what percentage of portfolios are they using it for? Are they using it for specific goals for their clients? How, how could you just talk about the use cases for that you've seen in the past year as advisors have allocated to this?

Speaker D: Yeah, so this is, this is a derivative income strategy. So a lot of advisors have a sleeve, uh, positioned for derivative income or equity linked income already. And so this fits squarely into that. The volatility profile of each of these strategies is designed to look like the underlying broad benchmark. So you take a volume targeted S&P 500, you ladder it out 52 or more times, you put a minus 40% barrier on all of those synthetic notes and you end up with a historic volatility that's about 18% right in line with the S&P 500, about 1.02 beta. Uh, just to continue on those stats, you would have received about 96% of all of those coupon payments. And you only would have breached your principal barrier a few times as a result of the global financial crisis. And that was about a 17% principal impairment. So not even the full 40%. If you go to CAIQ, that benchmark, you would have received 97% of the coupons and you never would have had principal impairment going back to 2005. That's about as far back as we can model to look at that. But we built this with a high degree of reliability into the income and then with a high degree of principal preservation over time. But the NAV will move a lot like the underlying. So about 18 for Chi and for Kai Q it's a uh, little bit higher which is, you know, in line with the NASDAQ 100 as well. So back to your question of how are people using this? You know you can use it as an equity replacement because of the volume profile. Some are using it as a high yield bond replacement. Looking at default risk of those high yield bonds during the financial crisis relative to some notes breaching their barrier in Chi's benchmark around that same time. You know I mentioned default risk and I think a lot of people's minds go back to Lehman Brothers or maybe AIG or banks or balance sheets that had a hard time paying out on their notes. So we have largely solved for that building back better uh, in the ETF wrapper. And we deliver all of the exposure to these notes via swap. And so we've built a laddered index with mercube, one of the best index providers that I know in the structured note space. We built a laddered index with them. We trade that index on swap and that is a fully collateralized swap. So what that means is that there is no counterparty credit risk like we would traditionally think of buying a note from a bank. We trade this swap on JP with JP Morgan, the biggest bank in the world. And so if uh, J.P. morgan goes under, you know, I think we probably have more problems in the world. But if they go under we have a backup swap counterparty. But this is a fully collateralized swap. So worst case scenario you'll be sitting in a basket of risk free assets that's remarkably liquid. You'll have the ability to get out that money sits at the custodian which uh, is assets inside the etf, which is a daily liquid intraday traded vehicle. You do not have to worry about JP reaching into its balance sheet. This is not a subordinated debt structure, this is a fully collateralized swap structure. And so we've largely eliminated the traditional counterparty credit risk like some people might be worried about.

Speaker B: So another thing, the time is flying by here. So I feel like we're just like kind of scratching the surface so try to get through as much as we can M before you know, without going, going too Much longer. But one of the other things I noticed is with, with the ka uh, Cage, you talk, there's talk about it having a memory feature. So could you talk, what does that mean?

Speaker D: Yeah, okay.

Speaker A: Yeah.

Speaker D: So our two income products that it makes up the largest segment of the structured note marketplace is derivative income. So we launched Kai, we launched Kai Q. Uh, and then there's another half of the auto call pie that some might not be familiar with and that's auto callable growth. And so you can think of the first two products as high stable income. Well, the third product, Cage, is designed for growth. We design this for amplified long term growth over time. That is the goal of Cage. And so uh, you know, the question you can ask yourself is if you're designed for growth, we no longer have to distribute the income to you. What if we just let it accumulate inside the fund? Well, if the goal is growth, then uh, we don't have to protect that income payment as much either. And so how we've built this product is a laddered portfolio of auto callable growth notes. And they have an at the money barrier that's observed annually. So no more minus 30% protection, no more minus 40% coupon protection. It's simply at the money that creates a very binary event where if the reference index is positive after one year, you're credited with a high coupon of about 25 to 30% in the fund. And if it's negative, you don't lose the coupon, you simply store it into year two. And that's the memory feature. So if the reference index is negative after one year, well now going into year two you don't have a 25% coupon, you have a 50% coupon, 25% from year one, plus the 25 from year two. So if at the end of the second year the reference index is positive even by a basis point, you're now going to collect 50% from that note. So it's a way to generate outsized performance over time. If you look at the index that we are trading, swap on the ticker is MQ autocg, uh, MQ autocg. You can see that on the Mercube website. You can go to Bloomberg and you'll see that over the last 20 years you would have done about two and a half times the S&P 500. Over the last decade, you know the market's been up considerably. You would have doubled your money every three to five years instead of the traditional seven years that the S and P has given you so think about someone who might be saving for retirement, who has growth as a goal, who can take on, you know, a little bit more beta to the S and P, a little bit more volatility. And now if you can double your money every five years instead of every seven, you know, you're going to have a couple more bites at the apple by the time you retire which will you uh, know land you in a phenomenal spot. So I'm 43, I've got actually 44 now, just had a birthday so I've got half my money in cage, uh, in my retirement portfolio. I put some of my kids in this as well. Hopefully they'll you know, wake up when they're older and thank me later. But yeah, remarkable growth engine for being able to get that outsized growth over time. Um, we didn't design it this way or to be a direct competitor to leveraged ETFs, but if you look at some of those daily or weekly levered ETFs, they have volume decay, um, which is a problem. You can't hold those long term because uh, if the market falls 10, you need a bigger than 10% recovery the next day to get back to where you started. Well, think again about our return to par mechanism if you see a big drawdown in the market. Each of these notes in cage has a minus 50% maturity barrier going back to.05. We've never seen a breach of that size. And so if you look historically you would have always either gotten a really high coupon or matured at par. Like that is the worst case that we've seen going back to.05. So you've got this long principal preservation built in uh, where you're snapping back to par, which again eliminates any type of volume decay that you would have otherwise experienced from a levered product. So a really interesting way to grow your portfolio over time. Cage for growth, Kai and Kaikyu for income.

Speaker B: Well on that note, yeah I think we've been going for, for a while here and probably should wind this down. So I uh, just want to you know, there's obviously a lot here and there, there's a lot for people maybe to continue to get their heads around. I know that you guys have also

Speaker A: put out a lot of of like

Speaker B: thought leadership on explaining these products, explaining the market. Where can folks find out more about auto callables and about what you guys have done?

Speaker D: Yeah, I would go to calamos.com we have a lot of literature that we've put out on this topic. As well. Um, JP Morgan has resources on auto callable yield notes that you might be able to look at. Doing it in the ETF wrapper we think has some advantages as well, being able to ladder out the exposures. And then I would also, you know, encourage you just to reach out to us. We are always available. We're happy to talk. Education is something that we've been doing for, for a very long time. We've been building spaces, you know, I would say for the last 20, 25 years. We built the smart beta space, we've built buffers, we built auto calls. And doing that requires a high degree of education and it has to be done with certainty. And so, uh, you know, we'd encourage you to just reach out and we're happy to walk you through one on one as well.

Speaker B: Well, I hope people also are getting a sense is one thing I appreciate talking to you is you lay things out in such a methodical fashion that it's like really easy to follow along, even when you're talking about things that inherently have some complexity to them. So I. Oh, good. Appreciate that. Yeah, folks appreciate that and, and, and get that when they reach out to you as well. So. Yeah. So, Matt, thank you again for your time and thank you for coming on the show.

Speaker D: Well, thank you. Always, always, uh, a pleasure.

Speaker C: David who. How can people get in touch with you if they have more questions?

Speaker A: Yeah.

Speaker B: For, for more information about our coverage and our podcast, you know, come to wealth management.com, read the investment section, follow the podcast on, uh, you know, all the, all the services. You could also always ping me on LinkedIn. I try to post all of our episodes there as well as. Although I probably should be better at posting more of it.

Speaker C: Well, thanks to both of you and thank you for listening today. Please like follow and share this podcast with your friends. Until next time, I'm, um, your producer, Wendy McConnell.

Speaker A: Are you a Series 7 licensed financial professional looking for more out of your career, like a stable environment where you'll get the support and resources you need to do your best work and focus on the client? Fidelity is currently hiring remot and in our branches. Join a financial services leader that cares

Speaker B: about the people on both ends of

Speaker A: the call, the client and the employee. Visit series7.fidelitycareers.com and explore opportunities Today. Fidelity is an equal opportunity employer.