It’s Not The Merit It’s The Price

My past self makes me cringe.¹

I remember a weekend Yinh and I spent in Big Sur before having kids. We stayed at a resort/hotel place for free in exchange for listening to the timeshare spiel. I’m just pushing back on every point, complaining about the math this poor lady on the bottom-of-the-realtor-totem-pole is conveniently ignoring. Looking back, I’m genuinely sorry to have been acting myself in that moment.

When you feel your blood pressure rising you can channel some grace by just thinking of someone you know who would be smooth in that situation. The aspirational move here is just smile and nod. I had the situation exactly backward — it was me who was embarrassing himself, not her with the canned pitch as pushy and nonsensical as it was.

Luckily I have this moon letter thing as an outlet for my teeth-grinding financial complaints. I’m over the timeshare sales thing (well, actually I just pay for a room and save myself the grief. I admit this feels more like a hair dryer solution² than addressing the root of my anger) and onto another — I can’t stand when a life insurance salesperson pretends they are doing god’s work by telling me about their widow client’s big settlement. I’m not against buying insurance — I have car insurance and life insurance. But I’m against motte-and-bailey persuasion techniques. If a widow getting paid is deemed a self-congratulatory act of corporate benevolence then Warren Buffet is the priest of puts, a hokey paragon of virtue, backstopping markets with the heart of a patriot. Ok.

Defending life insurance by focusing on the settlements that get paid out is as silly as branding calls sold as income. And for the same reason — there is no consideration of price. Let’s compare:

Defense of insurance: “Look at the settlement the policyholder received. It has so many zeros in it.”

Rebuttal: That would be true even if the insurance cost twice as much. So the issue isn’t whether there would be a settlement it’s the proposition on the whole.

Defense of covered calls: “The premium you collect is extra income, and if the calls go in-the-money you’ll be happy anyway”

Rebuttal: This would be true if I sold the calls for 1/2 the price that I actually sold them for.

In other words, both of these defenses are empty words because they skirt the defining point:

It’s not the merit of the idea — it’s the price.

The wrong price will ruin any proposition. Ideas without prices are worthless. “It’s a good idea to brush your teeth.” But if brushing your teeth took 8 hours a day, you’re better off pulling them all and getting implants.

“It’s a good idea to get insurance” has the invisible qualifier “assuming the price is reasonable”. From there we can debate “reasonable” and we should. But I assure you the percentage of time spent in a life insurance consultation that’s devoted to decomposing its cost is not commensurate to how important it is in the decision.

Money Angle

Let’s harp on this “merit cannot exist independent of price” idea. We’ll return to insurance for a moment.

The griftiness of insurance sales as a function of complexity is an inverted U curve. Term insurance is not complex, it’s highly competitive and low margin. Private placements, which I’ve written about, are sold to very wealthy people who likely have a CFO-type managing their money. It’s the midwit crowd from all ends of the income spectrum that express their snowflake exceptionalism in exactly the wrong place and end up paying for their agents’ kids’ private school tuition.

Many insurance products are complex and seriously difficult to understand — every now and then I’ll take a hard look at one and just think, “they expect the average person to comprehend what’s actually going on inside this black box?!” And of course, the answer is “no”. That’s actually the point.

Here’s a tip — run away if you can’t understand the insurance product better than the salesperson. This is not as high a bar as you think. Salespeople are experts at sales not financial engineering. If they weren’t selling annuities they’d be selling cars or homes. (It’s a blanket statement so there are exceptions — but you know who will agree with me the most? Nerdy advisors who don’t have perfect teeth. This is the old Taleb bit “surgeons shouldn’t look like surgeons”.)

When I look at insurance products, especially structured products, I look for the options embedded in them. The costs for these options is opaque. Many of them have analogs in the listed options markets, but ultimately the ones buried in insurance policies resemble illiquid flex options with long-dated maturities and substantial padding added to their prices. If you wanted to be rigorous about valuing an insurance policy you’d need to know everything from the value of these hidden options to how much credit risk to discount the various issuer’s policies by. Apples-to-apples comparisons are impossible. This de-commoditizes the products giving unscrupulous salepeople ample room to practice their dark art.

An aside about options thinking

I know someone who negotiates and prices leases for commercial office space. They work on huge leases with clients like FAANG. One of the things they mentioned was how they would try to embed provisions in leases which were basically hard-to-price options. The person also spent a couple years with an options market-making group and is generally very quantitative — I would use the person for math help regularly.

I also know of a few wildly successful option traders who did quite well in personal RE investing by structuring options with potential sellers (one of these stories was focused on an ex-colleague of mine which was discussed in a certain big city’s media post-GFC).

And one more related bit — an option manager I know is friends with a fund manager who deals exclusively in the pre-IPO share market. This is a class of funds that provide liquidity to late-stage VC portfolio company employees. The manager was able to help the fund manager by showing them how a particular option embedded in their structures was deeply mispriced.

A final aside on the usefulness of option thinking…in Option Theory As A Pillar Of Decision-Making, I include this:

Getting to The Price

A current example of the need to assess a proposition by understanding its price comes from the boom in covered-call ETFs. Jason Zweig of the WSJ recently published:

Why Investors Are Piling Into Funds That Promise Not to Beat the Stock Market (paywalled)

After great returns last year, covered-call funds are all the rage among income-oriented investors. But their high yields aren’t a free lunch.

The article covers the explosion in AUM in covered-call funds like the JPMorgan Equity Premium Income ETF (JEPI) or Global X Nasdaq 100 Covered Call ETF (QYLD).

These ETFs manage roughly $20B and $6B aum respectively.

We’ll talk about QYLD because its holdings are published while JEPI is a discretionary, actively managed ETF. (But I still want to know who gets to hungry-hungry hippo those option orders!).

QYLD sells covered calls on the Nasdaq 100. That means it sells a call option while owning the underlying index. If you buy 100 shares of QQQ and sell a call option you could do the same thing. That’s not an argument against this product though. Ease is a valid use case for a product.

More background: it sells the 1-month at-the-money call as opposed to out-of-the-money calls which is what people generally think of with covered-call strategies (when I was just a boy they called these “buy-writes” but I haven’t heard that term since Arrested Development was on the air).

I’ve addressed “selling options for income” as euphemistic, sales-led framing. I’m not necessarily opposed to selling options but when you brand it as “income” you are blatantly misrepresenting reality. You are pretending the option premium is income when the bulk of it is just the fair discounted weighted average of a set of possible futures. My bone with the marketing pitch is that there’s no discussion of price. Again, whether this is a good strategy depends on price and the price isn’t static. (I feel like like I’ve force-fed you like foie gras on this topic. If I have to hear about this “strategy” from one more medical professional I hope I better be sedated on an operating table so I can finally drown it out)

When the marketers show me the level of implied correlations they are selling in the calls then we can have a good-faith conversation. Or how about when they tell me who the buyer for those calls is? Because I can assure you there’s no natural buyer — the boys and girls buying those calls are only doing so because they are too cheap. They didn’t wake up in the morning and think “I’m not going to look at prices, I just think owning call options that go to zero is a reasonable way to invest my money.” You know what traders are thinking when they see the marketers pitch: “Thank you for stocking the pond, we’ll be waiting”.

And they will be waiting. Market-makers are lions in the bush who know the dinner’s migration patterns. Unlike lions, they need to be discreet. You can’t just pounce and scare everyone off. You don’t want to make a scene. So they pre-position.

The market-makers’ pre-positioning serves a dual purpose.

1. It spreads the market impact over a longer window of liquidity. This is actually pro-social — it’s “markets properly working”. The telegraphed order is not as scary even though it’s a large size because the end of it is known and there’s no adverse selection risk. It’s what’s known as a “dumb” or uninformed order. It’s not reasonable to expect zero market impact because unless there’s someone who wants to buy all these options, the pool of greeks need to be absorbed by a get-paid-to-warehouse-risk-in-exchange-for-profit entity. The market is just an auction for that clearing price and the greeks dropped on the market will be recycled in adjacent markets emanating from the original disturbance. (I.e. the market makers will buy vega from you and sell it in some other correlated market where the entire proposition presents an attractive relative value play — it’s just a big web. Market-makers are the silk between the nodes.)
2. You want the option seller to get filled near the offer so they feel good about the fill. That’s what it means to “not leave a scene”. So now that you are short vol 3 days ahead of the anticipated arrival of the order, knowing that the current vol level incorporates the impact of your own selling, you are ready to buy the new supply “in line”. Remember this is not frontrunning. It’s a probabilistic bet. The market-makers have no fiduciary duty to the fund (as opposed to actual frontrunning where the broker trades ahead of an order they control). Market-makers want the brokers to “feel” like they got a good fill. There are no fingerprints. A TCA that looks at execution price vs arrival price is already benchmarked to a mid-market price that has been faded to absorb the flow.

What does this mean for the cost of something like QYLD?

A napkin math approach

Assumptions:

• At the current AUM, they sell about 5,000 NDX at-the-money call options (equivalent to 200,000 QQQ options) every month.
• Implied volatility is about 25% so the fund collects 2.89% of the index level³ in premium monthly. (Can you see how ridiculous it is to call this income? Would you call it income regardless of how little premium it collected? What if the option was in-the-money and they collected the same amount of premium? Conflating premium with income is a timeshare tactic except it’s pushed by corporations who know better not Jane “it’s this job or dogfood for dinner” Doe.
• The ATM call is pure extrinsic value.

The question is how much vol slippage can we expect on that order. I asked around and a full vol point seems like a reasonable estimate. Because of the “setting the table” pre-positioning effect it’s hard to get a perfect answer. So we’ll use 1 vol point and you can adjust the final analysis by changing it.

If there is 1 full vol click of slippage and the option you sell is pure extrinsic, than you are losing:

1 vol point / 25 vol points x 2.89% of AUM x 12 months in annual slippage.

That’s 139 bps in annual slippage. That needs to added to the 60 bp expense ratio for the fund.

So you are paying 1.99% per year for a beta-like exposure created with vanilla products. And the alleged income is not income. It’s a correctly priced option premium in one of the most liquid equity index markets in the world.

Even if I grant you a 10% VRP (variance-risk-premium is an idea that options are bid beyond their fair value for any number of reasons like convexity-preference, hedging demand, or the possibility that markets allocate prices according to efficient portfolios and single assets being mispriced might not be from a portfolio point-of-view) that means the alleged income is 10% of what the marketers claim.

This whole trend in covered-call ETFs feels more like an innovation for getting paid for commoditized exposures in a fee-compressed landscape than an innovation that actually improves investing outcomes.

An (Overly) Candid Opinion

I’m not some socialist arguing against giving people an abundance of choice. I just want to remind you that no smart-sounding idea gets a free pass without consideration of its cost. And my own wholly personal opinion is you are paying a lot for convenience here. Plus the more AUM these things get the worse the slippage.

A saying I repeat too much: Asset management is the vitamin industry. It sells placebos. It sells noise as signal.

The proliferation of option products seems like something devised by products people not alpha people, a complaint I’d charge against most of the asset management world (which probably means I’m being too harsh but also I’m not criticizing any single firm — I don’t even know anything about these large fund companies because they were not part of my career genealogy. To me, they were always just the names of customers). Another reason I should be softer on all this is that, in aggregate, active management is critical. But there’s a paradox of thrift thing where we should (and this is dark) encourage it for others but not subscribe ourselves.

If you are truly obsessed and love investing then you can figure out your own way and maybe I’m just a faint admonishing voice in the background that you mostly ignore (I do hope I help you think better around the edges at least). But for the casual investor whose targeted by pitches and thinks they are missing out, you are given permission to live FOMO-free. There’s nothing to see except a midwit trap.

[And definitely don’t look at these. Gag me.

Actually, any TSLA options mm wants to gag me for raining on their parade. That should tell you something.]

Footnotes

1. This is good and bad. The good is that means I’m growing, the bad is I know my future self will cringe at 2023 me
   
2. Slatestarcodex once a story told about a psychiatric patient his clinic was helping. The patient was crippled by OCD. Every time she left the house she needed to go home because she thought she left the hair dryer on. The doctors racked their brains trying to get to the origin of the problem until someone suggested a highly effective but, seemingly unsatisfying solution — she could just bring the blow dryer with her:Approximately half the psychiatrists at my hospital thought this was absolutely scandalous, and This Is Not How One Treats Obsessive Compulsive Disorder, and what if it got out to the broader psychiatric community that instead of giving all of these high-tech medications and sophisticated therapies we were just telling people to put their hair dryers on the front seat of their car? But I think the guy deserved a medal. Here’s someone who was totally untreatable by the normal methods, with a debilitating condition, and a drop-dead simple intervention that nobody else had thought of gave her her life back. If one day I open up my own psychiatric practice, I am half-seriously considering using a picture of a hair dryer as the logo, just to let everyone know where I stand on this issue.
   
3. Annual vol = 25%
   Annual ATF straddle = .8 x Vol = 20%
   Annual ATF call = 1/2 * 20% = 10%
   Monthly call = 10% / sqrt(12) = 2.89%