Liquid Strategies Insights & Commentary

Manager Commentary - Q4 2019

Author: Shawn Gibson
Shawn Gibson

The final quarter of 2019 was one of the significant milestones and achievements for Liquid Strategies, marking the 6th full year of managing a conservative, risk-controlled option writing overlay program designed to add excess return to fully invested portfolios with a modest increase in overall portfolio volatility. In addition to applying the overlay program on top of existing client assets on a customized basis, the application of the Overlay expanded to provide separate account and packaged solutions (funds and ETFs) to allow the overlay to sit on top of six core underlying sources of beta: 1) Large Cap U.S. Equity; 2) Small Cap U.S. Equity; 3) Non-U.S. Equity 4) Core Bonds; 5) Municipal Bonds; and 6) Short-Duration Bonds. For investors that would have been invested in these various strategies since the inception of the firm, below are the illustrative long-term performance results:

ANNUALIZED SEPARATE ACCOUNT ILLUSTRATIVE RETURNS (Net1)

11/01/2013 - 12/31/2019

  1 YEARS 3 YEARS 5 YEARS Inception to Date
Large Cap Equity + Overlay 34.35% 15.62% 13.90% 14.93%
S&P 500 Index  31.49% 15.27% 11.70% 12.68%

 

Small Cap Equity + Overlay 25.55% 8.72% 11.69% 11.86%
S&P 600 Index 22.78% 8.36% 9.56% 9.70%

 

Foreign Equity + Overlay 17.70% 10.74% 8.82% 8.05%
MSCI ACWI ex US 21.51% 9.87% 5.51% 3.95%

 

Core Bond + Overlay  11.25% 4.74% 5.36%  5.64%
Bbg Barc US Agg Index 8.72% 4.03% 3.05% 3.27%

 

Municipal Bond + Overlay  9.80% 4.96% 5.46% 6.25%
Bbg Barc Muni Bond Index 7.54% 4.72% 3.53% 4.23%


1
Net of fees assumes a 0.75% management fee applied monthly. These returns are illustrative, hypothetical numbers representative of two actual return streams (Liquid Strategies Overlay and the underlying index ETF). The numbers illustrate what would have happened had we taken the underlying index ETF returns and added Liquid Strategy Overlay returns to them. Source: Morningstar, Liquid Strategies.

OVERLAY + SHORT DURATION FIXED INCOME ANNUALIZED PERFORMANCE (Net2)

11/01/2013-12/31/20191

  1 YEAR 3 YEARS 5 YEARS Inception to Date
Theta Income Strategy 6.90% 2.50% 3.36% 3.13%

2Net of fees assumes a 1.00% management fee. 

The value proposition of our solutions is the ability to add long-term excess returns above passive benchmarks through the risk-controlled Overlay. While the overlay may create periods of short-term underperformance, the long-term results of the Strategy are clear. In addition to the compounded excess return illustrated in the above table, a key benefit of the Overlay program is a high level of consistency in generating alpha:

  • Over 70% of all monthly returns have been positive
  • 75% of all quarterly returns have been positive
  • 5 of the 6 years have been positive
  • 80% of the rolling 1-year returns have been positive
  • 100% of the rolling 3-year returns have been positive

The possibility of success of the Overlay is supported by the Volatility Risk Premium (“VRP”) embedded in options. The VRP effectively represents the overpricing of options due to 1) the market routinely overestimating future volatility, and 2) option sellers demanding a premium for taking the risk from option buyers. Looking back over the past 30 years, this VRP has been positive in all but 1 year.

VRP ChartReturns and statistical information presented are for the period 01/01/1990 through 12/31/2019. Past performance may not be indicative of future results. Average Risk Premium Table is calculated using 1-Month S&P 500 Index Implied Volatility minus 1-Month Realized Volatility of S&P 500. Source: Liquid Strategies and CBOE.

It is important to note that when looking at a more granular level, there are occasional quarters (roughly 10% of all quarters) that have a negative VRP due to short-term market shocks. While these short-term periods of negative VRP can create short-term losses for the Overlay and most option writing strategies, these periods of stress are critical to the long-term sustainability of the VRP. Without them, option writers would not be able to demand as high of a risk premium. As such, advisors and their clients that utilize our solutions have long-term views and consider short-term periods of stress as opportunities for the Strategy.

A common question from investors is how much longer can the market volatility stay so low? This a great question that has a very complex and uncertain answer. The best starting point for thinking about this is getting a historical perspective. Equity market volatility tends to move in long-term cycles, or regimes, between low volatility and high volatility, with these regimes typically lasting about 5 years. The current low volatility regime has extended past 7 years. Below is a chart for the annual average level of the CBOE S&P 500 Volatility Index (“VIX”):

Annual Average VIXSource: CBOE, Liquid Strategies

For perspective, a VIX level of 16 represents an expectation that the market will move about 1% a day. As the following charts illustrate, daily moves of 1% are in the minority of market moves. Since 1990, the S&P 500 Index has only averaged a daily move greater than 1% in 6 of the 30 years and the most 1% moves in a year were about 133. Furthermore, the number of days per year that the S&P 500 Index moves up or down by more than 1% is about 63 days per year (out of 252 trading days).

Average Daily MovesSource: Yahoo Finance, Liquid Strategies

Number of Daily Moves Per Calendar YearSource: Yahoo Finance, Liquid Strategies

The factor that really drives the VIX Index to extreme levels are outsized daily moves of over 2%. As can be expected, 2008 had the most such moves at 72, while other years like 1992, 1995, 2004, 2005, and 2017 had 0. 

Number of calendar moves +-2Source: Yahoo Finance, Liquid Strategies

Returning to the question at hand, the periods of higher volatility/ larger daily moves coincide with periods of high uncertainty, particularly economic uncertainty, and are usually associated with a recession. Any of the following factors (as well as a number of currently unknown ones) could increase the risk of a recession in the next 18 months, driving equity volatility higher along with it:  1) Global trade relations (particularly with China); 2) stability in the Middle East; 3) U.S. Presidential election; 4) slowing labor market and consumer/business confidence. While many investors may think the VIX is too low given these risk factors, the largest pricing input for the VIX, by far, is backward looking as opposed to forward looking.

As we move into the new decade, we look forward to doing our part in helping investors successfully navigate what will undoubtedly at times be a challenging investing environment for equities and bonds. As always, we appreciate your continued support and interest.

As always, we appreciate your continued support and interest.

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Shawn Gibson, CIO, Portfolio Manager
Brad Ball, CEO, Portfolio Manager
Adam Stewart, CFA, Portfolio Manager
Justin Boller, CFA, Portfolio Manager


Learn more about Liquid Strategies and our process in our most recent White Papers, subscribe to our mailing list and visit liquidstrategiesllc.com 

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Disclosures
Income dividends may be paid quarterly or annually. If required, Capital Gains are usually distributed in December. Dividend and capital gain distribution amounts are reported on year-end account statements mailed in January and on form 1099-DIV, mailed by February 15th.The share price of the fund is decreased by the amount of the per share distribution to shareholders when dividends and distributions are paid. Internet sites do not adjust charts and pricing for these distributions. This results in misrepresentation as an absolute decline on charts, even though there is no change in the total return of the fund. The same disparity can arise with common stocks and is not exclusive to mutual funds.General: For further details on fees, please refer to Part 2A of Adviser’s Form ADV. Inherent in any investment is the potential for loss. Past performance results are not necessarily indicative of future performance results. All specific securities mentioned in this presentation are shown for illustrative purposes only. There is no guarantee that such securities will be used in the management of your portfolio as market conditions, prices or expectations of the manager may change at any time without notice. This email is not meant as a general guide to investing, nor as a source of any specific investment recommendations. This email makes no implied nor express recommendations concerning the manner in which any client’s accounts should or would be handled. The actual characteristics with respect to any particular client account will vary based on a number of factors including but not limited to: (1) the size of the account; (2) applicable investment restrictions in place, if any, and; (3) market exigencies at the time of investment. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. The investments and services to which portions of this presentation relates are only available to persons with a categorization as a qualified client, as defined under Rule 205-3 of the Investment Adviser Act of 1940, and other persons should not act or rely on it. Indices used for correlations are the Bloomberg Barclays US Aggregate Bond Index (“Agg”), Bloomberg Barclays Municipal Bond Index, ACWI ex US, S&P 500 Index, and S&P 600 Index. Hypothetical/Illustrative: Hypothetical performance is not an indicator of future actual results. The results reflect performance of a strategy not offered to investors during the time indicated in the analysis and do not represent returns that any investor actually attained. Hypothetical results are calculated by the retroactive application of the Overlay strategy constructed on the basis of historical data combined with other existing independently-managed ETFs and based on assumptions integral to this email which may or may not be testable and are subject to losses. General assumptions include: The manager would have been able to purchase securities in a single portfolio with similar characteristics to the Overlay Strategy and the Index ETFs recommended by the illustration, and the markets were sufficiently liquid to permit all trading. Indexes used for comparative purposes cannot be traded, however there are securities, funds, and similar investments that can be purchased to obtain similar results and include no fees. Changes in these assumptions may have a material impact on the hypothetical returns presented. No representations and warranties are made as to the reasonableness of the assumptions. This information is provided for illustrative purposes only. Actual performance may differ significantly from hypothetical performance. S&P 500 Total Return Index - An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of large cap stocks. All cash distributions (e.g. dividends and income) are reinvested. Used as a proxy for "Stocks" above. Barclay’s U.S. Aggregate Bond Index - A broad-based index of bond securities used to represent investment-grade bonds traded in the U.S. The index was formerly known as the “Lehman Aggregate Bond Index”. Used as a proxy for "Bonds" above. CBOE Volatility Index ("VIX") - An index sponsored by the Chicago Board of Options Exchange (CBOE) that shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of various option expirations and various strike prices of S&P 500 index options. Correlation (R2) - A statistical measure of how two financial instruments (e.g. securities, indices, etc.) move in relation to each other. A correlation of +1 implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, the closer correlation is to 0, the less the movements of two securities are related to one another. Beta - A measure of the portfolio’s sensitivity to changes in the benchmark. A beta of 1 indicates the portfolio has historically moved with the benchmark. A portfolio beta greater than 1 indicates the portfolio has been more volatile than the benchmark and a portfolio beta less than one indicates the portfolio has been less volatile than the benchmark. Beta in this presentation is calculated using monthly historical returns. Sharpe Ratio - A measure for calculating risk-adjusted return. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Subtracting the risk-free rate from the mean return, the performance associated with risk-taking activities can be isolated. Sharpe ratio = (Mean portfolio return − Risk-free rate)/Standard deviation of portfolio return.  For Sharpe Ratio calculations in this presentation, the “risk free rate” is represented by the annualized monthly returns of the 3 Month US T-Bill. Max Drawdown - A measure of the largest single drop from peak to trough based on monthly portfolio returns HFRX Absolute Return Index - A stock index designed to measure absolute returns. The absolute return index is actually a composite index made up of five other indexes. This index is used to compare the absolute returns posted by the hedge fund market as a whole against individual hedge funds. Standard Deviation - A measure of the dispersion of a set of data from its mean. 

Topics: Overlay, Volatility

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