#FASuccess Ep 411: Getting Clients Comfortable With Market Risk Using A More (Options-Based) Measured Risk Approach, With Larry Kriesmer

Resources Featured In This Episode:

• Larry Kriesmer: Website | LinkedIn
• The Determinants of Portfolio Performance
• Technical Equities
• Series 4 – Registered Options Principal Exa

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Full Transcript:

Michael: Welcome, Larry Kriesmer, to the "Financial Advisor Success" podcast.

Larry: Thank you, Michael. Thanks for having me.

Michael: I appreciate you joining us today. And I'm excited to nerd out a little bit, I think, on portfolio and investment theory. When I started my career, I got going right in the early 2000s, and that was the heyday of both the first generation of variable annuities with the living benefit lifetime income riders that got much more popular in the subsequent years. And it was also the first generation of what we now call fixed index annuities today. We called them equity index annuities back then. They were these annuity contracts where you could invest in annuity. And back then, they were often quite simple, at least compared to many of the products today. You just might sit down and say, "Well, here's a contract. You get 80% of the upside of the S&P 500 for the next 7 years. And if markets are bad, then you get your money back, or maybe even plus a small nominal return." Risk-averse clients liked it. You had a floor, and you still got a big old chunk of the upside of the market. You cut off a little bit of the top, and you cut off a lot of the bottom.

And I was fascinated with them at the time and trying to understand relative to investing directly in equities, and this is the early 2000s, so we're coming off of 9/11 and the tech crash, and these 40%, 60%, 80%, 90% declines in some stocks. This idea of you still get 85% of the upside or so with no downside was really neat. And I was like, "How do you do this?" And went and talked to some folks that I was able to meet in the insurance companies and found out, "Well, basically, they just buy a whole bunch of Treasuries, and they use the interest on the Treasuries to buy long-term call options. And if you get enough yield, you get enough upside. And if it goes badly, they just give you your Treasuries back." And I thought like, "Wow, that seems really neat and simple and kind of straightforward way to invest," except at least at the time, we were still calling in trades on the telephone into the home office. It was like I was never going to be able to implement this at scale with clients using options that way.

But in the years since, this has evolved in a lot of ways. We have more indexed annuity options than ever to do this. Now, versions of it have gotten packaged into various types of structured note arrangements, structured products out there. We get a whole range of buffered ETFs that do a version of this as well. And then I kind of come across your firm, and I think our conversation today that does what I at least think of as a more plain vanilla straightforward way of doing this, which is you just literally buy Treasuries and call options for clients and do it yourself without all the additional middlemen layers that otherwise get in there when you've got structured products and buffered ETFs and indexed annuities and the like. So, I'm excited today to just talk about how these strategies actually work, like how you do this in the "real world" with real client dollars trying to invest portfolios this way.

When Risk-Tolerant Clients Cannot Handle Volatility [07:15]

Larry: Yeah, excellent. That's exactly what we're doing. The genesis of this is the equity-indexed annuity products. That's what got us interested. But the reason we got interested in this in the first place is the same. We came through the tech bubble, and we were early adopters to the ETF models, and we're using fancy software in the late '90s and early 2000s to try and optimize our portfolios. But I think the real problem with a lot of these strategies is that you look backwards to see historical performance, and you attempt to model something that'll perform well going forward. And it never behaves exactly what you expect to going forward. It's going to behave close or similar or something. But I'm sure almost every advisor that's listening is going to realize that they've looked at something, built something, and then had correlations change when they were most inopportune time to change.

Michael: You use what's there, and you hope it's at least a decent representation of the future, even though it's clearly not perfectly predictive.

Larry: What got me really bothered, frankly, 2 things. One, I had a client early on when you start in this business, and you make a recommendation, and then the markets start to go south, and that position or that strategy starts to perform not the way you'd hoped, call and say they wanted to sell it. And it rocked me because it threatens my own credibility, my judgment, and the lack of ability for me to correctly assess what the client's risk tolerance was. And it's very difficult to go through that process. It's more difficult for the client, but it's tough on the advisor, too, because it really does start to put a doubt in your mind and question whether or not this was good for them or maybe even not good for other people you have it in. So, it really is rough.

And the key thing that I've finally learned, and this is something that is maybe going to resonate, is that it's not so much the decline that is causing the client to want to get out. It's the lack of knowing how bad it's going to continue to be. That's the part that makes people come unglued because they know going into it that they're going to have some volatility and it doesn't just go straight up. It's going to go up and down. But when something has lost 10% or 20%, or fill in the blank, whatever percent it is that has met that person's risk tolerance, and you either reach out to the product sponsor or the manager or the client reaches out to the advisor and says, "Well, how much worse do you think it's going to be?" And the honest answer has to be, "I don't know," or, "I think it's as bad as it's ever been because historically, it has never got this far. That's not going to give the client any kind of confidence to hold the position. So, I was really hell-bent on trying to find something that would work differently. And that's what this does.

Michael: That resonates with me a lot, that framing that it's not really the decline that causes the client to get out, it's that they still don't know how much worse it's going to be from here. I remember sitting...early in my career, I sat second chair for a long time, but sitting second chair to an advisor who had a super risk-tolerant client, serial entrepreneur type who took what most people would consider to be extraordinary risks over and over and over again with multiple companies that he'd been involved with. And he had basically got 100% equity or equivalent portfolio, and he couldn't sit through the tech crash and ended out panic selling shortly after 9/11. And there was this internal discussion of, I think, a version of what you said, right? You start having the self-doubt of what happened.

And the realization that we came to is it doesn't really matter how risk-tolerant you are. If you actually think the market's going to go to 0, you still get out. I mean if you really think it's going to be that bad. And back then, very high-profile companies were literally going bankrupt and losing 90% to 95% write-offs. So, that felt like a very proximal possibility. And so, we watched this incredibly risk-tolerant client still not able to "tolerate" the markets. And it was only in retrospect kind of realizing, we looked at the decline and said, "Well, these things happen with volatile markets and then it comes back." And his perspective was, "I don't know if it's going to come back. I don't know if we're just halfway to 0. I don't know how much worse it's going to be. And I think there's a real possibility that the whole thing is blowing up. So, I just want out."

Measured Risk's Investment Strategy [12:02]

Larry: Yeah, exactly. So, back to geeking out on the strategy, for those people listening who don't really get the exact structure, it's the use of a zero-coupon bond or a discount bond. So, mechanically, on a million-dollar portfolio, you're going to end up, let's say, putting $950,000 into a Treasury. And that's going to grow back to a million dollars. And that million dollars is the floor of the guarantee or the ability to give your principal back. That's assuming roughly about a 5% yield in a universe. If you're in an 8% yield universe, then $920,000 goes into the bond. If you're in a 3% yield, then $970,000 goes into the bond. But whatever it is, it's going to come back to a million dollars. That then leaves you with the balance to put into options. And it's just that straightforward. So, if you have a $950,000 example going into Treasuries with a $50,000 future value on maturity, that leaves you with $50,000 today that you can actually invest into the options.

The structure then is what can $50,000 do? And in most cases, $50,000 can't give you one-to-one participation with no cap. There isn't enough money in the yield to be able to buy you an option that will accomplish that. So, that's why the products will sell a call above the current market price, and that will give you a cap because you get to participate from the current market up to the cap where you've sold the option above it to bring the cost down of that option to what you have to work with with yield. And then when you add in from a structured product the need for the manufacturer to make an income, then it's going to be even less available. So, what we did is we looked at that as the model and said, "Well, okay, that's a hell of a thing. I understand now we can attach ourselves to the index and get exposure to upside," because the Treasury will go up in value and mature at its par value, and then you're going to add back something or nothing from the options. The options will either be worth something because the market went your way, or they'll be worthless because the market didn't. And that's how these things are built.

What we did at Measured Risk is just change the idea that we're not necessarily needing to come back to par. We actually do have tolerance for risk, and by that, I mean we don't need you to give me back a million dollars. I'm okay with 950,000 as my ending value, or maybe 900,000 as my ending value, or even 850,000. You know, it's a 15% decline. So, if you agree that 850,000, the 15% risk budget, is what's acceptable, that gives us something close to 20%. Not quite because if we put $800,000 into a Treasury, we're only going to grow back to maybe 840,000. So, maybe it's 810,000 or 820,000 goes into the Treasuries, and that'll grow back to 850,000 at the end of a year. Well, that gives us 3 times the buying power, 3 times the amount of capital that we put into an option contract, and gives us that much more horsepower. And as a result, we don't need to sell a covered call to reduce the price. There, I've just given away the recipe. That's effectively 99% of the heavy lifting. There's a couple things that we do that are proprietary that we'll hold on to in the conversation.

But what you find then is that you have just the market moves up, and when the market moves up, these options that we select are specifically designed to move much faster. They're levered, but not borrowed, so there's no borrowing cost associated with this, but they are highly levered. And that return we're shooting for something like an option that'll move between 8 to 12 times the rate of the market. So, if the market goes up 1%, we're hoping that our option value will go up 10% to 12% in that same time period. And mathematically then, if we allocate 10% of the portfolio to something that can go up 10 times as fast as the market, it'll move equivalent to the market. And then part two is that we don't do this on a point-to-point structured note kind of basis where we're issuing "something" in January and waiting until December to see what happens. We buy our option contracts based on when the money is received in the client account. And then if the option is performing and the market's rising, we may sell that option contract in 3 days, or 5 days, or 3 weeks, or 5 months. It's all dependent on whether or not the market's moving. But as soon as that option has become monetized in a way that it starts to outperform its index or its stated target, that's kind of our signal to sell that particular option contract, harvest the gains, put the gains into the relative safety of the Treasuries, and then redeploy the capital out into a new option tranche.

Michael: All right. So, I want to make sure I understand the pieces here. So, the starting point really is like the good old...I think of it now, like the good old plain vanilla original indexed annuity structure as well. Like I buy enough Treasuries to replace my principal at the end of the time window. I take whatever's left, and I buy options, and you get some level of participation in the market. The better the yields, the less you have to put into Treasuries, the more you can put into the options, and the better the upside that you get. So, when I think back, when these were happening in 2000, I don't remember exactly, but I think you were getting 6% on a money market, like 7.5% on a 10-year back then, if I'm recalling correctly.

Larry: That's pretty close. I think when we started, our first trades in this strategy was taking place in 2006. And it was about a 5.5 to 6.5 [percent]. So, 5.5 on the government and 6.5 [percent] on corporate paper.

Michael: So, when you're at that level, I guess, can I translate it this straightforward that, again, you kind of said...I'm sure this is rule of thumb because we're grossly oversimplifying options pricing, but like, "I might get a 10X movement factor. So, if 5% of my portfolio can go into options that in the first place that I may be able to replicate 50% of the upside participation." Does it translate that straightforward?

Larry: Kind of close. Yes, exactly. Right. So, obviously, it's going to be subject to option pricing, but the bottom line is you can't get one-to-one participation typically with the yield coming off of Treasuries.

Michael: Right, because there's not enough yield there to do it.

Larry: That's correct. Yeah. We found that when markets are normalized and things are not crazy because of some big VIX spike or something or big trading vol event in the markets, that maybe 7% to 8.5%, to maybe 9% is the cost of an option contract at the money, so at the price of the market today for about a 1-year duration, which is what we typically do. We buy enough duration on the contract so that we have enough time to go through a trough and recover coming up the other end. But it doesn't get down to where it's the same as the yield on the Treasury. So, that doesn't happen.

Michael: Okay. So then, if I'm thinking about this in the traditional construction, like option strategy construction world, if I'm going to use my yield to buy a call option that's right at the money so that I'm actually able to participate outright from dollar one, again, I'm probably oversimplifying here a little, but I've got 5% yield to invest, but unfortunately, I need like 7% or 8% yield to actually fully capture this. So, the way that companies might have done it historically is they say, "Okay, I'm going to buy my call option at the money, but I'm going to sell a call option that's good ways out of the money. That might give me back 2% or 3% yield. So now, I can take the 5 [percent] cash that I had, the 2 or 3 [percent] that I got back. Now, I can actually buy my call option at the money and participate in the market right from where it is. But because I had to sell some distant out-of-the-money call option to make this work, I'm not going to get any appreciation above that threshold. And now, I've effectively introduced my cap. So, I buy my option here, I sell my out-of-the-money call option at plus 15% or plus 20% on the market. And now, I can participate in the upside of the market, but nothing above where I sold a call option, but that's what gives me the money to capture everything from here going up. And I've got no downside because, again, if everything goes wrong, my Treasuries are still coming back to mature at par in this scenario."

Larry: Exactly. Except you've set the number too high. It's nowhere near 15% or 20%. It's typically closer to 7%, or 9%, or 11%, or something relatively near is what's necessary to sell. And that's what I found to be not attractive about the equity index products is that really this wasn't an equity anymore. It was just a fancy bond with an interesting crediting rate.

Michael: Right. Because if the plain value really comes down to...I get 0 if markets go badly, I get up to 9 if they hit their plain vanilla cap, and markets are going to bounce around in between. I start doing math and it's like, "Well, on average, I'm going to get probably mid-single digits because sometimes I'll hit the cap and sometimes I'll hit the floor and sometimes I'll hit something in between. So, it averages out somewhere in the middle, and mid-single digits isn't terribly appealing because then I could have just bought the bond."

Larry: Right. And not gone through all the exercises. So, that was really the idea for me that what we wanted to do is make sure we could build a product that didn't have a cap or build an exposure that didn't have a cap.

Michael: Okay. And so, that's why then you start coming down and saying, "Okay, instead of buying enough Treasuries that this will mature. My original million dollars will mature at a million again. So, I'm floored where I am." I say, "No, no, I'm only going to buy enough Treasuries that even after they appreciate and mature, I'm only going to finish with 900 grand of my original or 850 grand of my..."

Larry: Right. And that's what's nice about this is it is client-specific. So, that decision is something that each client makes based on their suitability. And it gives them a defined amount of capital, a drawdown risk that they can decide in advance so that when or if that event occurs, then it's disappointing, but it's not devastating. And it's not the kind of news that will upend the apple cart. It just is disappointing.

Michael: Because the whole point is, literally, the worst-case scenario is we own a stack of Treasuries, and here's what they're going to mature at.

Larry: Yeah, exactly. And that confidence is so important. It's unbelievable, the difference between going through a volatility event when you have 85% or 90% of your portfolio in Treasuries versus going through the same volatility event when you have a diversified basket of stocks and bonds and mid-cap and large-cap and all of it's moving around in some terrifying mass. Frankly, that's what the client sees anyway. We professionals know what we're doing, but it's not as clear to external.

Michael: Well, I feel like it's a version of what I think a lot of us as advisors went through over the past few years as interest rates shot up and bond portfolios took their hit. And at least for some segment of us that used the strategy, we were buying individual bonds, maybe we were buying letter bonds, maybe we were just buying individual short to intermediate-term bonds. And you just sit across the client and say, "I know it's gotten marked down a little right now, but you literally just have to hold it. It will mature at this."

Larry: Right. Exactly.

Michael: "We just have to sit here and watch it. It's going to go there." And there is a definite comfort for a lot of clients that comes from individual bonds where you can point to maturity times and maturity dates that just doesn't show up in the same way with a bond fund where you can kind of explain the underlying dynamics, but it doesn't feel the same as, "Oh, I see the line item and the exact date that it's going to mature back in my original principal."

Larry: Yeah. I'm going to talk, too, about what's interesting to me, I think, and it may be the part that has really settled for me as being appropriate and normal is that instead of trying to build a basket of securities that has a hopefully variable frequency of gains and losses, so I'm having some non-correlated behavior in the portfolio, but each and every one of those positions really has no limit on what it can lose and the amount of volatility that it represents. But that buy seems to make sense for people. If they're going to buy, I'm not going to name names, but stock A, B, C, and D, they are actually putting capital and buying something that can go down in value. Whereas our strategy with Measured Risk is really more that we're going to invest only 5%, 10%, or 15% into an asset class, which is options, that can lose 100% of its value. And it's not theoretical, it's actually probable if the market doesn't go in a direction that we want it to go. We lean into that instead of being afraid of losses, we get to celebrate and use the math and say, "Well, now, we can define what the losses will be in advance of the event and structure in a way that it can't turn into something worse." That's the difference. And that simple math calculation is what separates us.

The Upsides And Potential Downsides Of Larry's Investment Approach [25:13]

Michael: So, when you do this with less of the starting principal, you've got enough dollars now that I don't need to do my...I'm buying at the money, and then I'm selling 9% out of the money. I can just buy full value at the money with enough options that they move at the amplification level I need to actually generate what's effectively dollar-for-dollar market participation. And there's no cover call at the upper end. So, there's no cap. The caveat is just if the market moves the wrong way, I'm not giving you your principal back, I'm giving you 90% back, or 85%, or 95%, or whatever the client defines it.

Larry: What we've found is that it's about 12% to 14% in that neighborhood is what's required really to get a structure that's going to be able to have a shot at participating as well as the S&P 500 does. That's what we tie our options to is the S&P 500. Really, you think about this, whether it's Buffett or the Vanguard folks or the old Bogleheads, they'll basically tell you that if you're a young person, you should just invest in a low-cost S&P 500 index fund and start buying it and continue buying it for 40 years and you'll likely outperform almost anything. And I don't necessarily disagree. I just have this problem that we've experienced in our lifetimes that every some number of years, that same index will shed 50% of its value and/or 30% or some very large number. And that is just really tough, particularly timing-wise, depending on how old you are and how much more time you have to go through.

But as a practical matter, if we can structure something that is similar, and that's what we actually trademarked a word this year, it's a combination of synthetic and equity, and we now own “SynthEquity,” and that SynthEquity approach is designed to try and mathematically engineer out the severe drawdown, but not mathematically engineer out drawdown. We're not trying to remove volatility. We actually need volatility because volatility is good if it's positive. It's just bad if it's negative, right? So, we want the volatility to occur because we want the options to respond and explode in value and allow us to harvest the gains from those options and get them off the table and put them into Treasuries. We just don't want to suffer a 30% or 40% or 50% decline.

So, if we can shallow the drawdowns to, say, something between 10% and 15% and still keep the majority of the upside and in some cases outperform the upside, then it has to make sense that over time, mathematically, that result will be as good or better than the underlying index of the S&P 500. And along the way, occasionally, when the market doesn't perform much, like it moves just a little bit or only declines a small amount, that can also lose the option allocation. So, we don't have to have the market declining 30% to lose the option allocation. It only needs to decline 3%, for instance, to lose the option allocation. So, in exchange for hedging out or removing, mathematically, the exposure to a 30% or 40% drawdown, we're introducing the potential for smaller losses more frequently, possibly. But even that will still mathematically keep up with the index. And that's what we've experienced in our actual trading experience.

Michael: So, is the goal of this at the end of the day...I think kind of generically, we're trying to reduce the drawdowns and still participate on the upside, which at face value, I think of that as, "Okay, so we're trying to beat in the long run because we have shallower drawdowns and 100% of the upside." So, in theory, we just ratchet ahead over time. Or is the reality, "No, no, no, you also get these shallow drawdown scenarios where your Treasuries don't mature back at full value and the market was slightly negative, so you don't get the recovery and you lose the options. You actually can get dinged slightly worse in a small drawdown scenario"? And when you net all that out, it turns out markets are pretty efficient and you really do kind of get the same long-term return you're going to get anyways, but at least you don't have the drawdown depth. You get to a similar point, but with a less volatile path along the way.

Larry: Yeah, that's what I'm thinking is the best description of this, is that we're not necessarily...we're going to be ahead if we measure from a point to point that includes things that we do well. We'll be behind if we measure in a point to point where we include some drawdowns that are steeper than what the market did. It's all dependent on when you get to the starting and the finish line.

Michael: I would think particularly the sensitive just when you start shaving off the occasional 40% decline in a bear market. It looks amazing if you do it right before a crash.

Larry: Right, but here's the big reveal, and this is the part where I really want people to pay attention. What we're showing you is that you can increase the allocation to that asset class. And that's the win because having a 60/40 or a 70/30 means that you're allocating 30% to 40% of the portfolio to an asset class that cannot compete against the S&P over time. It just can't. It's not going to keep up. And by using a synthetic approach and SynthEquity, you can actually tilt the wheel much higher. That's the win.

Michael: So, the idea is my moderate risk client, I might not have put into more than a 50% or 60% equity allocation, but say, "No, no, no. If I could show you a version that never had a drawdown worse than 15 [percent], would you be willing to go 80 [percent]?"

Larry: Exactly.

Michael: And now, I won't necessarily do a better than 80 [percent]. The wobbles might average out to an 80, but you're willing to do an 80 with a shallower drawdown that you might not have otherwise been willing to do at all in the first place.

Larry: That's correct. Yeah. In fact, think about this. If 60% of the portfolio, which in traditional equity portfolio, is allocated to something like the S&P 500 or its constituents, and we agree that some of the severe type of 1-year drawdowns can be, let's say, 40%, that means that 60% of 40% is 24%. That's the contributory loss of just the 60 side. And so, let's then just say theoretically that the 40% does a tremendous job and it makes a positive 10%. Well, that positive 10% on the fixed income side is only going to be 40% contributory, so 4% credit. So, in your moderate portfolio, you're facing a drawdown in that kind of scenario of 20%. And that 20% is only the theoretical floor because if the markets got worse, the losses just continue to get worse. There isn't anything stopping it from getting worse.

And you contrast that to this SynthEquity approach. And if your Treasuries are allocated at, say, $840,000 at the beginning of the year, and we know they're going to grow back to something like $860,000 or even...in 2019, there's no yield on the interest rates, really, and so, we didn't get any yield from our portfolio. We just don't want it to go down. So, we know what the floor is. So, that is going to grow back to something mathematically... Let's give it high certainty. I don't want to say guaranteed necessarily because we could always have a problem with the U.S. government. But let's just say from a baseline, it's as safe as we can think of. And we're also doing very short duration. So, we just don't have any risk tolerance in the bond basket because we're taking all the risk we can, which is a risk of total loss in the option basket. But that puts you in a position where mathematically, as you said earlier, you're right, and you can't draw down more than 15% if you've got the structure in a way that prevents it from happening.

How The Measured Risk Approach Fits Within A Broader Asset Allocation [33:06]

Michael: So, when you talk about this in the context of maybe my 50/50 [50% stocks, 50% bonds] client goes to 70/30 or 80/20 or something because they're more comfortable with an equity allocation that's got some guardrails on it or whatever you want to call it, does that mean I should think about this as my equity allocation or my equity sleeve or a substitute for my equities? Meaning if I'm looking at this from a holistic portfolio perspective, I also still have a bond allocation. I mean, you hold a lot of bonds because that's part of the Treasuries plus options. I've still got a bond allocation somewhere else if I'm doing commodities or alts or whatever. I still hold those in other portions of the portfolio as well. Is it fair that I should think about this as this goes in the equities box of what I'm investing my client for?

Larry: Yeah, it can. I think this is where it starts to get to be really challenging for the advisor because, honestly, my approach is that it is just a replacement, honestly, for diversification because the idea of having a diversified portfolio is a requirement when you don't know what the risks are. So, you're allocating to different locations. In this respect, we've defined what those risks are so you can make a decision about how much you want to have of it. But what we found is that this, if we do studies using YCharts or Morningstar, and you do some hypotheticals of just basic math, the initial one was, "Okay, let's take a 60/40 portfolio and put our strategy into the 60 and see how it does." And it does better. It does materially better because of the lack of drawdown in that 60% bucket. Then you do the really crazy thing is you put it into the 40 side. So, you replace the bonds with it because if you think about this, you're already prepared to take the risk of the 60. So now, let's say about making the 40 behave nicer with a relatively modest increase in risk because, again, that strategy has risk characteristics that can be not much worse than the AGG [iShares Core US Aggregate Bond ETF], frankly. So, that is a huge home run. That really improves things, but it improves it because you're effectively going to more of a 100/0 portfolio instead of a 60/40.

Michael: Interesting. Yeah. So, it reminds me of some of the early conversations, again, around equity index annuities. We said these were equity index annuities, and we talked about them as alternatives to having straight equities that had better floors and more protection. And then the conversation started to crop up of, "Well, with these floors, your return profile is much worse than bonds." Is the index annuity an equity substitute or a bond substitute? And went down the same conversation road. So, it sounds like you've now arrived at a similar conversation or context here. If the client already said they're comfortable with the equity portion of the equities, this doesn't necessarily have to replace the equities. This can amplify bonds with not substantively different profiles. Because as we saw with recent interest rate increases, you can have some decent-sized losses on some bonds in any particular year.

Larry: Yeah, exactly. So, that's an interesting approach to think about that. And it's all geared, though, toward... I geeked out also in the early days of my career. And things like the Beebower and Brinson study, the Determinants of Portfolio Performance, that study kind of laid the groundwork for most of a client's experience and investment performance over time is going to come from the asset allocation decision more so than these timing or stock selection and when you buy and sell or what stocks you buy and sell. That's, I think, reasonably agreed upon that it's predominantly where you asset allocate is going to make the decision or make the biggest impact on performance over time. So, that allocation, if you could increase the allocation in equities from 60 to 80 [percent] or from 80 to 100, that impact over 15 or 20 or 30 years is going to be huge compared to the difference in whether or not you have a stock selection that includes one stock over another or was bought or sold at the right time. And that is really the crusade that I'm on right now is trying to show people or at least point out that you might have more risk tolerance than you can imagine if you use the tools and options.

And so, I almost feel like we're being given the tools and we're even being told, “This is the playbook by which you can structure things to survive.” And then you arrive at a broker-dealer or you arrive at a shop and the person there, doesn't know what to do with options. And they literally just say, "Well, don't ever do those, that's too dangerous."

And so, I like to really stress that option contracts aren't really scary. They're just a mechanism to move money from one pocket to another, from one person to another person under terms that are understandable. And you just have to spend some time to understand what the terms are going to be to then make a decision about whether or not the price you're being offered, the premium, is the right premium to pay. And if you don't want to pay that premium, then you move around with different strikes and different durations and set it at a place where you find that your comfort level is for whatever outcome might happen. That's the trick. And that does take some experience. And that's what we're trying to bring to the table for people.

Building The Investment Strategy With Treasuries And Options [38:40]

Michael: So then, take me one step deeper in the actual building blocks of how this comes together. So, I guess just starting on the bond side, on the Treasury side, well, I guess, first, is it really just Treasuries? Are there other things you mix into the bond side of this portfolio, or are you really buying Treasuries?

Larry: Yeah. Over the course of doing this for 20 years nearly, we have put other pieces in there, and it's always been not worth it because if we're trying to squeak out an extra 25 or 50 basis points of yield, invariably, that comes with 500 basis points of volatility. And we just don't have the budget for that. So, today, and going forward, it's U.S. Treasuries because they are just the greatest at doing their job, which is to hold onto their value and not introduce any shenanigans into the portfolio part that we have no tolerance for additional volatility.

Michael: If this is your safety anchor portion, let's not get fancy with this.

Larry: Yeah, let's not try a new type of metal that's probably not corrosive in salt water. I don't want to find out, once the storm hits, whether or not I've got a good piece of anchor line. Exactly.

Michael: So, is it buying straight T bills? Is it buying...

Larry: Yeah, we're just buying.

Michael: ...intermediate notes? What do you buy?

Larry: We're just buying the current Treasury notes that are available to us in a 12 months and shorter, and we build a ladder. Every 90 days, we've got a good chunk of the portfolio coming due. And that gives us the ability to replenish the options if we've gotten to our full term. And in 2022, it was a negative year. Market went down initially, stayed down, never recovered. And those options that we bought in the beginning of the year expired worthless.

Michael: So, you're not even taking a couple of years of duration exposure. This is rolling 90-day maturity.

Larry: Yeah, it goes up to about an average 6 month maturity on U.S. Treasuries. Very, very short. We get a little bit of wiggle from interest rate movements, but we're talking about sub-50 basis points.

Michael: And laddered and staggered so that you've always got cash coming due to buy or roll options, I guess, so that you don't even have to deal with the liquidity risks of needing to sell Treasuries when you might not have wanted to sell Treasuries…

Larry: Right. But it wouldn't be an issue because if we've owned them for more than a couple of months, then we can likely sell that Treasury at a gain, even with a rapidly rising interest rate.

Michael: For those unfamiliar, so what leads them to sell to gain at that point?

Larry: Well, just for liquidity. In other words, if there was a knock, knock at the door and the client needs $100,000 out of their $600,000 portfolio, we can likely pull $100,000 out without having suffered a loss on the Treasury component. The options obviously could be down but the Treasury should be fine.

Michael: So then, how does it work on the options side? What length of maturity are you buying options?

Larry: What we're doing there is we're looking... In both cases, it starts not from the Treasury or the option. It starts from the risk budget. So, the client has to have a risk budget. We have 3 sleeves. We have a growth sleeve, a core sleeve, and a lite sleeve, but it can be customized down to the percentage to the client. And each of those sleeves has either a 12.5%, 10%, and 7.5% risk budget. What's interesting about the option allocation is that it doesn't take much more to go from being a 50/50 to a 100/0, is only about 5 percentage points of options. That's how strong they are. And you can go higher. You could do 120/0 portfolio by allocating more to options. You can actually get higher than the market if you want to scoot up the options over sort of the growth level, which you can do. But we just come up with a risk budget. So let's just say, for argument's sake, easier math is 10% to the risk budget, then that determines what we have to spend. And then that spend is given a little bit of a boost by the future interest credit. So, in other words, we know if we put 90% of the portfolio into Treasuries, we're going to earn something back. And so, if the client's risk budget is 10 [percent], we actually can spend more than 10 initially because of that yield. But in times when there is no yield, then 10 is what it is. We just only have 10, and that's what we spend. So, that then is reverse-engineered to attempt to...how we're going to get really geeky here on options. So, buckle your seatbelts.

Michael: We'll see how we see. I can do in a audio-only podcast with no slides.

Larry: Yeah, with no charts and graphs. Right. Well, I think if you have any kind of experience with options at the money, so in other words, if the market is at $5,000 and we buy a strike at $5,000, we would anticipate that...it almost doesn't matter with duration, whether it's a month or a week or a year, that the delta, which is this measure of the movement of the underlying risk relative to the movement of the option, will be about 50%. And that just means that if I buy an at-the-money option contract, I would expect that the next 1% movement up in the market is going to give me a 50% or 0.5, half a percent movement in my option. So, we have to adjust the number of contracts and some other slight features that we do to make it so that we're attempting to get our delta to become 1. And then that will give us the strike that we need. And all that moves together to come up with what our budget is and what the strikes are. And that's how it works. So, it's really very mathy. It's not anything else.

Michael: And so, as you wind down that formula, I guess the risk or the challenge is if the risk budget turns out not to be enough, you can't quite get the delta to 1, and you effectively don't track to 100% of the upside of the market. You're only getting 90, or 80, or 70, or some lesser amount.

Larry: Yeah, that's very budget-determined, obviously. And I think I've mentioned that it's about 12.5% to maybe 14% is what's required to get to that one-to-one relationship. So, if you're down around 10%, you would be expecting, and that's what...our 10% allocation is probably equivalent to about a 70/30 performance expectation. That's where we would expect to fall. But here's what's interesting about options. That same option that you buy at the money that has a 0.5 delta, as the market rises, it's no longer at the money. It becomes in the money. And that delta doesn't stay static at 50. It goes to 52 and then 56, then 58, then 61. So, the longer you hold it, the more appreciation per basis point it captures. And so, the participation curve is not linear. It's logarithmic. It goes higher and higher as the market goes higher. So, even if you start out with a, let's say, underperformance relative to whatever benchmark you're up against, within a period of percentage points, that starts to catch up and then accelerate past that performance level.

Michael: So, thus part of the ongoing management and rolling and resetting of options because your allocation, whatever your target was, whether this was supposed to be something tracking to a 50/50 portfolio or something tracking to a 100% portfolio can get too hot after a period of time.

Larry: Yeah. And all of these things are coming from whether it's Black-Scholes, or some other fancy pricing model, or even what the trading software that we're using is telling us what these deltas are, that is merely an educated guess. It's not promissory, in other words. It's just going to give us a guideline to get to where we need to be. The market will move tomorrow in the way the market moves and the response of the options will be somewhat predictable but not spot on. And so, this is all just a close kind of thing that we're doing. It's not meant to basis point by basis point track to some index. We're just attaching the strategy to an engine, which is the S&P 500 that pumps up and down. And we're doing our best to model it so that we are getting close participation. Sometimes we'll be behind, sometimes we'll be ahead.

Michael: And then I'm assuming that as a baseline, you're buying longer-dated options so that you don't just flat-out run out of time while you're trying to manage the rest of the strategy.

Larry: Yeah. This time decay happens. An option contract is like a lit fuse. As soon as you buy it, it's got a finite life and it's headed toward death. You either have to monetize it or sell it before it expires, or you're going to hold it to expiration and then it will turn into cash or securities. So, it's got a definite amount of time on it. And we've observed that the time value decay is typically much faster in the last few weeks and months of its duration than it is with 9 months or 12 months to go. So, that time decay is less and that's why we use a relatively longer-dated option contract so we're not up against a rapidly burning fuse.

Michael: And does that mean part of the goal is you're buying multi-year options and then actually rolling and resetting them to re-up for longer-year contracts so you're just always staying further out on the time curve as it were?

Larry: That is, again, that part of that factor that goes into setting the duration, setting the strike and within our budget. So, there are multiple inputs that we're using there. But ultimately, we're looking for about a 12-month initial maturity, and then that maturity will instantly become shorter tomorrow because we're 1 day less. So, it's always coming at us, and we're measuring what is appropriate. We would attempt to typically try and extend the duration when we have a profitability event like if we've purchased options for $200 and then we're trading them out at $260, we might take that opportunity to roll to a $220 or a $225 longer duration strike, which is more than our original purchase but less than what we're harvesting for.

Michael: And then what is the trading software, the portfolio management tools? How do you manage to this in practice to figure out how many of what options at what strike to buy, how do I accurately figure out what the delta is and then monitor the deltas over time?

Larry: There isn't a software product that we could purchase, so we've built this in-house. And that's the proprietary key to the kingdom for us, and there wasn't a tool that was designed for this because there isn't anybody doing this. That's why we have to build it ourselves.

Michael: So, I guess there's not off-the-shelf options analysis tools and the like that works for you and what you do?

Larry: Not specifically for what we do now.

Scaling The Strategy Over Time [49:46]

Michael: So, as you're implementing this...so now, I get it in the individual context. So now, how does this work when you're doing it as a firm?

Larry: So, as a firm, it's just a function of applying...honestly, Excel is our friend. Well, it's because it's math. The great thing about this strategy is it's math-based. And the only part that is not perfect in my mind is the rounding of option contracts. We can't put 2.4 contracts into your portfolio. We have to put either 2 or 3, and so in smaller accounts that can be a meaningful disparity in the allocation because we have, let's say, an option contract might control on the S&P 500 $500,000. 1 contract is $500,000 worth of capital, so it's a big difference between 1 and 2 contracts. We use the S&P 500 SPY also for 1/10 of that. So, even on that though, we're talking about $56,000 of risk per 1 option contract because it's 100 shares of the underlying. So, going from 1 contract to 2 contracts is taking your notional exposure from call it $56,000 to $112,000 today.

Michael: And so, just as with any client, if you're buying in $56,000 units, this may not line up well. And the smaller the clients, the bigger that swing can be.

Larry: Exactly right. Exactly. So, that's something we can't fix. That is what that is. And we take great pains to explain to that that we can manage this strategy in smaller accounts, but we have to be aware that the difference between $56,000 and $62,000 won't be a difference in option contracts. There's a rounding there that can take place. So, that's important to understand. But otherwise, you just...

Michael: So, is there a minimum in practice about how far down you'll go with it, like how far down on the portfolio size you'll go before...?

Larry: Yeah, we really don't recommend below about $55,000, $60,000. That's really where it needs to be.

Michael: That's still a sizable amount. So, it's not $250,000 or $500,000.

Larry: No, it works much better at those larger sizes because we're still only talking about maybe 4 or 5 contracts at $100,000. And so, $200,000 is 1 contract and 4 contracts is 25% more contracts. So, it's a mathematical percentage, big difference. If you have a million dollars, then we might be going from 40 contracts to 41 contracts and it's not as big of a difference.

Michael: But you're not managing this on a pooled basis like it's in a fund. This is still like every client's got their individual account, their individual allocations.

Larry: Yep, exactly. And so, that process is...and I'm sure people know how to trade blocks. We just see a book of business, and we know what each account balance is worth, and we can do the math to figure out how many contracts they need. And then you just add that all up, and we'll trade 2,000 contracts of this or 450 contracts of that, and then we allocate it back to the client accounts.

Michael: Because I was going to ask in that category, so I guess implementation for you is still a version of how other advisors might run a model account approach. So, you've got a standard model, or I'm presuming several, the high-risk folks that get the 100% participation, the low-risk folks who have the smaller risk budget. But everybody in the 10% risk budget has the same 10% risk budget, which means they're buying the same quantity of Treasuries, which means they're participating in the same options. And so, just as any of us who put a model portfolio in place, all your clients in the 10% risk budget model can still be handled in block trades and managed to a model. So, it scales across the firm at that point.

Larry: Yeah, it scales across the firm. And it's why we've decided to open it up to other advisors and seek out those relationships because we really have the capacity now to manage thousands of commas and zeros. I can't manage more client relationships, but I can certainly manage more accounts. So, that's really where we find ourselves.

Michael: Are there challenges with account types, just what can own options of various types and not between taxable accounts, retirement accounts of various types?

Larry: Yeah, well, the retirement accounts in a real pension plan, like not just a single K or something at a custodial account, but in a real pension plan, then the trust document itself has to actually allow for options. And that's obviously required. But the migration from TD over to Schwab was challenging because there were definitely some account types at Schwab that they had just marked down for not being approved for options. And that wasn't the case at TD Ameritrade. So, it wasn't a statutory or legal issue. It was just a risk level. It's another risk consideration that Schwab just had a more, I guess, aggressive risk control policy. And so, we've been working closely with Schwab to expand that appetite.

Michael: So, for advisors that have experienced things like you're not allowed to own options in an IRA, that's not a tax, investment, legal restraint. That's a some brokerage platforms just don't want to see options in IRAs because they don't want to manage the risk exposure of them.

Larry: That's exactly correct. And I think it's twofold. It's easy to understand why. Because if you buy a traditional option, like you want to buy a call option to limit your risk and still participate in the upside of the underlying security, so you go out and you buy 3 contracts of options on the SPY for the S&P 500, if you're not managing it properly, and you buy a call and it's successful, and that call becomes in the money, if you don't sell it before the expiration date, then you're obligated to buy those shares at that price. And you could maybe not have enough money in your IRA to actually pay for those shares. You could end up to where you owe somebody $320,000 for something you're about to get $400,000 worth of value for, which is fantastic. It's an $80,000 gain, but you might only have $60,000 of equity in your entire account. And that would be not enough to pay for the shares. And so, to avoid that risk, and also because you can't do a margin call and add $400,000 to your IRA if you don't have the capacity to pull it from somewhere else, and you can't make a contribution to an IRA. So, you can't even make the person fill it up to meet the obligation. So, I'm using big numbers, but it works even with $4,000. It doesn't have to be huge.

So, I get what they're doing, but it's not that it's illegal or against the rules. It's just that it was a risk type of a thing. And so, you just have to kind of communicate that with the custodians.

Michael: Okay. Because at the end of the day, custodians don't want to be in scenarios of, "So, your $60,000 IRA has a $400,000 margin call. How are we going to work this out?"

Larry: Yeah, they don't want to be there. Right.

The Tax Implications Of Using Options In An Investment Strategy [56:49]

Michael: So now, help me understand the way this works from a tax perspective as options roll and things come due.

Larry: There's good, bad, and the ugly, I guess, in all things. And so, the good is that the recognition of gain is occurring all the time. Because if the market's going up, we're actually selling these calls well before their expiration date. And since we talked that we're not going to buy more than about a year out, that means we're not holding these options for more than a year. So, we're not going to set ourselves up for a long-term capital gain on the contract themselves. However, the good news is the SPX contracts, which is, unfortunately, the area of large account balances, they have a special tax treatment. There's something called 1256, or basically, it's in the commodity space. And cash-settled contracts, these are contracts that don't deliver shares. They deliver money for their economic value, similar to pork bellies and wheat and corn commodities and futures and stuff. They are subject to a special tax treatment where 60% of the gain is credited as long-term and 40% is short-term, regardless of the holding period. So, if I buy an SPX contract on Monday and I sell it on Friday for a 23% gain, 60% of that is going to be treated as long-term capital gain.

Michael: And so, that becomes, I guess, a distinction between large clients that can buy $500,000-plus single contracts versus smaller clients that have to buy it on the underlying ETF or smaller units. If you can afford the large chunk versions, you can get the 1256 treatment of 60% long-term, 40% short-term. If you have to buy the smaller version of the options, I guess it's all short-term gains. It's all ordinary income.

Larry: Yeah, it's all ordinary income. That's correct. So, in that respect, IRA is obviously great place to put this or have this or a Roth IRA. If it's a taxable account, it's still reasonable. I mean, it's great risk controls, but you're always going to be recognizing the gain. It's going to be ordinary income. So, it's going to be at a high rate.

Michael: Okay, okay. And then the bond Treasury side is just good old-fashioned taxation of Treasuries as they mature?

Larry: There is one other interesting thing that clients really appreciated in the 2022 tax year, and that is the gains on these 1256 contracts. I think we're all familiar, hopefully, that if you have a loss and you can carry that forward indefinitely until you have an offsetting gain, that you can use against it. But unique, I think, to the 1256 contracts is that you can actually go back and retroactively file your losses in this calendar year to previous gains in 3 of the previous years. So, you can go back 3 years and apply losses and get refunds.

Michael: Oh, interesting. So, in 2022, I guess, when markets did funky, unpleasant things, again, if you're buying the big contracts version, the losses you're booking, you can actually turn into immediate refunds for prior gains. You don't have to wait until you've got current-year gains, which, unfortunately, you tend not to have in really bad years.

Larry: And what's great about that is that if you think in terms of, "Okay, we have a negative 2022, we find ourselves in the first quarter or second quarter," depending on when you're doing your taxes, you can go back and file an amended 2019, '20, or '21, depending on where or if you had the gains in those years that you can use, and it has to be the same type. So, it's 1256. You can go back and amend and get a refund. And it's not like going to an ATM. The money doesn't come in 10 days, but it does come reasonably soon. And then you have potentially the opportunity to redeploy that capital into the depressed market you're still coming out of.

Michael: But the caveat is you can only net these back to prior 1256 contract gains?

Larry: Yeah, I think that's the case. It's got to come off the same thing.

Michael: Okay, so not as helpful if my losses happen to come in the first year of the strategy.

Larry: Yeah, otherwise, you're just in the same boat. You're going to be waiting to do this. We haven't talked about positioning for a loss, but it's a very important consideration, too, in this strategy because we as advisors, and I think even investors, general retail public knows that you want to buy low, and the opportunity to buy low comes during these market crises, when we have a sell-off. The challenge is that, again, in a more traditionally diversified portfolio, a lot of the positions can be negative. And from where are we going to get this buying power? And the structure with Measured Risk and SynthEquity, when there is a negative event like in 2022, you are literally sitting on a pile of Treasuries. Your whole portfolio becomes Treasuries because the options have lost the majority of all their portfolio. So, our strategy won't re-risk the portfolio for you, but you as an investor, or you as the advisor can certainly reach out to us and say, "We'd like to allocate another 2% to options, or we'd like to just make a straight-off purchase of something," because it's in the SMA space, or separately managed accounts, all of that is available. But that's something that is really important to talk with the clients about because it can set them up to be brave when everyone else is afraid.

Preparing Clients For Sizable Losses On Individual Options [1:02:21]

Michael: I was going to ask just on the client communication end, I get the framing upfront of “Here's your Treasuries that are going to form a floor, you can't go lower than this because we literally own Treasuries, and they're going to mature at what they're going to mature at. The options then will be your engine here if markets go well. They'll make big enough gains to replicate what you need. If markets don't go well, then the worst-case scenario is they go away, and reminder again about those Treasuries that are going to mature at their value.” So, I totally get how the strategy comes together. I'm still trying to visualize, but now I'm going in with my client for a review, and the markets are down a bit. And the good news is we've totally still got your Treasuries doing all the things they were supposed to do. But I'm going to walk in with a statement where my client's got negative 100% line items for a bunch of options that went to 0. Just how does this work from the client conversation end?

Larry: Yeah, well, that is part of the pre-sale positioning or the pre-allocation positioning. They have to know going into it that that is, again, not just a possibility, but a probability that you're going to suffer a loss. And then again, the 100% loss only comes if it's held to expiration because there'll still be a little modicum of time value right up until the expiration date.

Michael: Right. Fair enough. So minus 94 [percent]...

Larry: Yeah, 94, 92, these are numbers that we've definitely seen. Well, okay, there is no better way to do it, except to just to go through it and remind the client that that is the budget that we agreed upon. So, I think I may have said earlier, it's the outcome that is disappointing but doesn't derail you from the strategy. And that you can't emphasize enough that you want to be clear on what the possibility is of loss on that.

Michael: Is there some version of clients where there's a risk tolerance problem because it works on the whole, but they're not going to tolerate the pieces?

Larry: Yeah, there's probably a client like that. What's more interesting, for instance, is we do have some spreads in this structure as well. And those spreads are not...they're sort of ancillary. They're not a big piece by any stretch, but they do use some spreads in there. And those spreads are generally designed to provide some very, very high multiple potential payoffs. But what ends up happening is that typically, the bottom side of that call that we buy might show a gain of 490%. And then we'll show a call that's above it that we're shorting, that the market has risen, so that short's gone against us. And we could be down like 540%. And that's when you start to really get people going, "What is going on here?" And, yeah, okay, that's going to require maybe a discussion. But I will say we haven't had a single externally advised account call us with that kind of a question. So, I think it's relatively rare.

Michael: And pricing-wise for what you do is, is this kind of traditional AUM fee structure, or how do you price one of these strategies?

Larry: Right. We price our strategies at basis points. And we attempt to work with the advisors that we work with to make it so that there is, let's say, an incentive to work as a larger allocation. We'll be able to pass on discounts as they allocate more capital to us.

Michael: So, graduated fee schedules and breakpoints?

Larry: Yeah, exactly.

Michael: As you do it on the retail end, just how does it price for you?

Larry: Yeah, on our retail, we do the same thing. We have a tiered fee structure, and that tiered fee structure starts out on the first $250,000, and then it hits breakpoints as we go lower. We also offer a performance-based model. And that performance-based model doesn't have any monthly costs, so there's no fee unless there's a high watermark. And those 2 are available based on the client's preference. And they have to qualify. The SEC has limits for who can actually participate in the performance fees, and we follow those rules.

Michael: I was going to say, how does the performance-based model work? Because that's not common that we see in the advisor world these days.

Larry: Yeah. for us, it's only about, I would say now, maybe 6% to 8% of our AUM is in a performance model. And for those people who are not really familiar with it, you have to have either $1.1 million invested with us directly or $2.2 million of investable capital, of which we can have any amount. But those are the 2 primary requirements to be qualified for this type of treatment with the SEC. And then we really find it's the clients who have a real problem paying a fee when the portfolio is going down. You know, there's just a psychological hairball that they get caught in their throat when they're required to pay for negative performance. So, we caution them that their fee structure is going to likely cost them more over time than they would pay if they just paid the normal fee structure. But you can have a period like 2022. Those clients didn't pay a fee for the whole year because the account was negative. And they didn't pay a fee for a couple...I don't remember exactly, but maybe 6 to 8 months into 2023 before they got out of the hole that they were in, and then they start paying fees again. So, maybe 14, 18 month fee holiday.

Michael: So what is the payment on the upside then? What is the performance fee participation that you ultimately get to withstand 16 months of not getting a check?

Larry: Yeah, it's 20% of the appreciation on a monthly basis, realized or unrealized. So, it's just basically a high watermark. And then as soon as that is debited, so let's say you have a million-dollar account that goes up $10,000 in the month, and that fee would be $2,000. And as soon as we take $2,000, the account balance drops to $1,008,000, and we won't build again until we get up above $1,010,000. So, we have to actually earn our feedback.

Michael: Except if you're replicating equity returns. And on average, equity returns are something in the neighborhood of 8% to 10% a year. People are going to end up paying you 1.6% to 2%, roughly speaking, with some volatility and stuff along.

Larry: Yeah, exactly. And it comes in a different stream because I think our best growth performance was about 36%. So, that fee, we don't charge at the end of the year. So, you don't earn all 36 and then charge a fee, but we charge along the way. So, that client couldn't get anywhere near 36 [percent] because they were paying 20% of the gains as they materialized. So, they may have only gotten to 29 [percent] or something as a net result for that year. But then '22 comes along, and they don't pay anything. And then they don't pay anything for a while because we have to recoup the losses. But it is clear to me, and we make it clear to the clients that that is likely going to result in a higher fee over time.

Michael: Because your baseline fee for a million-plus-dollar client is not 1.6% to 2% as a baseline.

Larry: Exactly right. Exactly.

The Time Commitment Needed To Implement An Options-Based Strategy [1:10:04]

Michael: So, I guess I'm just curious, for folks who don't have the depth or expertise around options trading in the first place, where does this go wrong? When people try to self-engineer this and don't know what they're doing, where does this go wrong?

Larry: I think it goes wrong in the time and budget. So, if you think, "Well, I don't really want to do a year's worth of options, I'm just going to do 3 months," and then you set your risk at, "Well, I'm not going to do 10%, I'll just do 5%," well, if you set a risk budget for 5% in 3 months, that kind of volatility can go negative very quickly, and you haven't given yourself enough time to recover. So, you have to go back into your Treasuries at the end of 3 months and re-up your 5%. The other thing that can be unnerving is that in the face of a market decline, option pricing increases because the predominant sentiment is typically that the potential for rebound and therefore relatively strong near-term equity performance gets better. And therefore, option pricing goes up. So, if you do have to reload the option sleeve right in the middle of a pretty severe drawdown, it can be expensive. And again, if you don't have experience with it, you might go, "Oh, this makes no sense."

But we've allocated fresh capital in the depths of the drawdown in COVID, in 2020, and we had tremendous performance to the upside, but the market just turned around and went on a tear. So, it's a possible thing. Where it can go wrong from someone DIYing it is maybe not harvesting the gains fast enough. These options move very quickly if you're buying at-the-money option contracts and doing some delta adjustments to bring the delta to 1 and trying to attempt to get the movement on par. If you're not watching it, you can quickly go from having, say, a 10% allocation to options to being 17% in options. And that 17% can turn right back to 2% in just a couple of trading days if the market pulls back hard because once you get over your skis and you're traveling faster than the speed of the underlying, the reversal of the direction is typically even more catastrophically participatory. It'll go even harder against you. So, you can be successful, build up the option balance, and then only to watch it all just go right back down to 0.

Michael: So, I guess that's also part of why you try to align a lot of Treasury staggered out over a year with the options maturity that starts or anchors around a year. So, you're kind of aligned that if things aren't cooperative, my worst case scenario is the yield of my Treasuries re-ups at the exact time that a year from now that I'll have to reload my options if I can't otherwise adjust along the way.

Larry: Correct. Or roughly, let's say, 20% because if we have some allocation to options, then we have not the full amount available in the Treasuries. But, yeah. So, it's roughly 20%, 22% of the portfolio is coming due every 90 days. And if I've just been unfortunate and I am on a 12-month journey to option expiration worthless, then I'm going to have some money arriving at about the right time to replenish the option engine.

Michael: So, help us understand just for a moment, like stepping back more broadly, the evolution of your advisory career, like how you came to be doing this with client portfolios. As you said at the beginning, I think you lived a world similar to mine at the beginning. You were in insurance, annuity world with Series 7 in life and health doing variable and index annuities. So, how do you get from that to this? What's the pathway?

Larry: I think it was severe dissatisfaction with what the outcome was for the client. That's really what it was. So, we haven't talked about loss in any significant way, but I am part of a family that my father was a victim of financial fraud in the '80s, a big one. Actually, if you want to have people look up Harry Stern and Technical Equities, it was probably inflation-adjusted, something similar to Madoff. And this firm up in San Jose was great at marketing and had lots of sports figures and former baseball players and football players. And they had nice events where people got to hobnob and stuff. My dad came in as a retiree from a big oil company overseas and brought his money back to the United States, gave it to this firm. And it was just 24 months to 30 months later that everything went upside down. And that was devastating for me.

But that to me gave me a taste of watching, getting a little heavy here. But my father really passed away as the man I knew, even though he didn't die for 30 years later. But the man that I knew and grew up with was lost. And that financial loss was devastating to him. And he felt like he had made a tremendous blunder and took responsibility for that failure. And to, I think, a smaller degree, that's how I felt when I shared that those clients initially made the call to get out of something that I put them into. I had a little bit of the same kind of feel. And what I was experiencing from those clients was that same devastating loss. And I just really didn't want to do that ever again. I wanted to bring something that would be much more secure, frankly, but still be able to be in the rewarding space that equities can do. And so, literally, engineering another solution that is going to run with that pack of dogs, but not be torn apart by it is what I wanted to accomplish.

What Measured Risk Looks Like Today [1:16:09]

Michael: And so, what does the advisory firm look like as it exists today?

Larry: So, as it exists today, we have 9 employees, a sales associate, and a bunch of administrative staff that are here to support the operations. And my partner and I are the lead portfolio managers. We have 2 traders that are executing the trades for us. And we're looking to build that out…we have potential capacity now for another thousand accounts, it wouldn't impact us at all with our current staffing level. So, I found really the best success is the independent RIA that has $50 million or $75 million or $200 million, and it's himself or herself and maybe 1 or 2 admins. That is really a sweet spot for us.

And what we're able to show them is that we can streamline the process of getting their clients exposed to equities in a really simple way. It's fascinating to me the number of people that will willingly believe that somebody can forecast what's going to happen over the next 6 months. But they won't believe that an option contract can deliver the returns that we're showing them if they can.

Michael: But it's literally contractual...

Larry: Yes, it's contractual. And this is math. Nothing weird is going to happen here. I don't know what's going to happen as far as the market going up or down, but I can tell you with great assurance what can happen to the possible outcomes given where the market is 6 months from now. And that to me is really what the firm is about. We're trying to get that message out.

Michael: And are you still doing this with retail clients as well? Because it sounds like that's where you started with this.

Larry: Yeah. In fact, the retail clients today are still the larger part of our AUM. We're just sort of embarking on this journey. You know, we'll celebrate the day that the externally advised assets exceed the internally advised assets. That will be a big day for us and a momentous day of celebration. And then we expect over time that that retail practice will become a smaller and smaller part of our practice and that it's still with us.

Michael: So, why the shift?

Larry: It's scale. We have about 400 accounts that we manage on the retail side. And realistically to do a good job with those people, I'm not sure we're in a position to go much significantly larger. And the ability for us to reach out and if I can help an advisor understand the meaningful benefit that this can bring to their practice, then they may have 200, or 100, or 300 accounts that they can apply this to. And then if I do another advisor and it's another 400 accounts, then we can quickly get to 7,000 accounts or 10,000 accounts and make a difference.

Michael: So, how many clients or what's the asset base for you at this point?

Larry: We have about $350 million that we manage currently. And I think it's roughly 2/3-ish is internally advised, about 1/3 externally advised.

What Surprised Larry Over The Course Of Building His Business [1:19:15]

Michael: Okay. So, what surprised you the most as you've gone down this path of building a business around this?

Larry: I would say I have disappointment in our colleagues because they just want a ticker symbol. The infrastructure of this practice, it doesn't play as well as I'd like it to play with other practices because we have to set up a separate account to do it. And you have to do something where we buy these positions. And that is the biggest hurdle. And I think it's the biggest hurdle why it hasn't been widely adopted as a strategy when you're asking the advisor to onboard a client relationship, explain the requirement to now add margin and options trading and what that entails. And if they haven't got it already in their practice, that's a big ask.

Michael: And so, it's challenging or frustrating for just the paperwork and logistical hassles that it takes in practice in our business to do this?

Larry: Right. Yeah. We have many people who have looked at this and said, "Well, this really is great. Let me know when you get it in an ETF." And they're just not willing to go through the effort to put it into a client account in a separate account.

Michael: So, how do you think about this as separate account versus ETF, versus structured note, versus buffered ETF, versus index annuity? I do feel like there's other ways that the industry has packaged this.

Larry: Right. Well, I think the challenge that we have is that we're exploring an ETF model, but we have a real challenge on our hands because we structured this as a defined risk kind of a product or strategy, I guess, is better way of saying this. So, if you have a client who purchases this...now, let's say, we'll wrap it in an ETF and it's bought with the expectation that you can't lose more than 15%. And then subsequent to that, the market pulls back. And so, let's say, 10% of that 15% has been lost. A new investor coming into that fund needs to understand that we can't put 10% of...or that we can't put 15% of their capital out because there would be increase in the risk to the other pooled member of the fund. So, we have to limit what we buy on a new deposit in a drawdown experience. And so, our biggest challenge has been trying to frame and work out the logistics of communicating that properly live because it will change from linear day to day to week to week.

And so, even if we are successful at getting an ETF constructed and get over the hurdles that we're trying to achieve for both the existing investors and the new investors, there will still be a case for the separately managed accounts because you have the unbelievable comfort of being able to look into your brokerage account and see those Treasuries and know that they are, in fact, secure.

The Low Point On Larry's Journey [1:22:21]

Michael: So, what was the low point for you on this journey of building the business?

Larry: I would say right in that financial crisis time period. It was rough in the tech bubble going through 2000, 2001, 2002 with sequential losses. That was really not good. But '08 was probably the worst because we had just developed this strategy. I was actually at a big insurance company, broker-dealer for a long time, 13 years or something before we started doing this. And I see the strategy in these annuities. And I went to the London conference and came back and talked to a client that had a million dollars with us, but it was the small fry account. His big money was over in Switzerland. And I sat him down and I showed him how the math would work. And I said, "Can I get your account fixed to do this? Would you be willing to experiment with me?" And he agreed, and so we did. And that was in 2006 and it worked. And we had proof of concept and started to onboard more clients internally as we went through reviews. And unfortunately, the general agent in our location wasn't able to pass the principal exam. And so, the Options Principal Exam was over that guy's head. And so, we were told we'd had to stop doing option trading, which obviously once you've tasted the sweet nectar of control, we're not going to give that up.

Michael: Because the general agent couldn't pass the options principal exam.

Larry: That's why we left. And so, that's what prompted the formation of our RIA in 2007. So, we are extricating ourselves from our mothership that we've been with for my whole career, and at the same time onboarding and doing all the paper transfers. We're attempting to meet with clients to then also do a transition over into the strategy. But sadly, '08 came upon us faster than we could get everybody into the arc. So, we had a number of clients that were more traditionally positioned still, and we hadn't had time to get to them. So, the losses were less for the clients that were in this strategy, but that was still substantial for the firm. And as every advisor out there knows, I think you typically would find that you have, let's say, for every dollar of revenue, about 50 cents goes to expenses, whether it's rent or staff or overhead, and then 50 cents goes to the advisor. That's their take-home pay or their gross take-home pay, I guess, before taxes.

And when the portfolio starts to get hemorrhaged, it's the advisor who suffers. You know, we can't close our office or send home our staff because, otherwise, we're really giving up. So, it's just brutal financially. And I was much younger then, and much less capital, didn't have as much available resources. And I came to my wife in November of '08, and even though we had a great strategy on our hands, we just hadn't enough time to get it in place in time. And we were just really close to going, "Oh my gosh, I don't know." I don't know, if you look back at the world back then, I was devastated that I had to hardscape my backyard because I was convinced I was going to have to grow my own food. And that was gnarly. So, that was a low point for us. We were definitely looking at the end of the tunnel and seeing the oncoming train headlights, not the light.

What Larry Would Tell His Younger Self And Newer Advisors [1:25:32]

Michael: So, what else do you know now that you wish you could go back and tell you 10, 15 years ago as you were starting to build a business around this kind of investment approach?

Larry: Well, I think the business, I have to say we've just always spent the majority of any gain that comes into the door…goes into more staff, more services, more marketing, more something. We don't strip it out and put it into our Wells Fargo or Chase account and spend it on stuff. So, that, I think, has been discipline that I've always had. And if you're going to share something with any advisor or any businessman, I think in that respect is the best return I'm ever going to get is out of the business that I'm running. And whether that's a street sweeping company or a printing shop or anything, that's where the greatest return is going to come from business owners in their own business. If I had any regrets on what I've done personally, I have not put enough money into that option part of my strategy. The reality is you look at that 100% loss potential and you go, "Well, 15% is a lot, but it wins way more often than it loses." And you just have to kind of have enough in there to survive the losses. That's the idea.

Michael: So, any other advice you would give younger, newer advisors coming into the profession today?

Larry: I think if your focus is on taking care of the client and doing what's best for that client, if that's what motivates you to do this, then the rest will just be a natural outflow of it. But if you're going into financial services because of the financial opportunity or dollar signs, then I think likely not going to do as well as you might have hoped.

What Success Means To Larry [1:27:21]

Michael: So, as we wrap up, this is a podcast about success, and one of the themes comes up is the word success means very different things to different people. And so, you build, like what everyone says, objectively, a very successful advisory firm with hundreds of millions of dollars under management and scaling up. So, the business seems to be in a wonderful place now. How do you define success for yourself at this point?

Larry: Yeah, I would say success for me is going to be able to be looking back on Measured Risk Portfolios when I have been out of the business for 10 or 15 years and continue to see it grow. So, if I have been able to lay the framework for something that has staying power and becomes something that is used by advisors either through us or because they're able to learn about it and adopt it for themselves, that to me would be a pretty amazing win.

Michael: Very cool. Very cool. What about for you individually beyond the business?

Larry: I have the PTSD of that financial fraud. So, for me, I would love...and I'm very close to be in that position where I don't feel like I can be knocked off financially, where there is just a...I work because of the joy of work and not because of the need for money, and that if I can structure my estate in a way that motivates my children to continue to work but makes it so that they are incentivized and maybe protected in the event of some bad events, then that would be great for me.

Michael: Very cool. Very cool. Well, thank you so much, Larry, for joining us on the "Financial Advisor Success" podcast.

Larry: You're very welcome.

Michael: Thank you.