In many ways, the topic of conversation for this episode revolves around what ultimately amounts to a fairly vanilla, almost-index like portfolio.
The asset class in question, however, may verge on the exotic for listeners with less fluency in the field of derivatives.
My guest is Eric Ervin, President and CEO of Reality Shares, and he has joined me to discuss their flagship ETF DIVY. I would argue that DIVY is one of the few exposures that fits the definition of both being liquid and alternative. By tapping into the OTC market, Eric and his team build a portfolio of 1-to-5 year dividend swaps, which have historically earned investors a unique return known as the dividend risk premium.
Eric’s confidence to bring such a unique product into the market was borne from his experience as an advisor, where he utilized alternatives extensively with his clientele. Learning more about this experience in evaluating alternatives and the mental framework he used that allowed him to allocate upwards of 50% of client portfolios to alternatives is where we begin our conversation.
Corey Hoffstein 00:03
Hello and welcome, everyone. I’m Corey Hoffstein. And this is flirting with models, the podcast that pulls back the curtain to discover the human factor behind the quantitative strategy.
Corey Hoffstein Is the co founder and chief investment officer of newfound research due to industry regulations. He will not discuss any of newfound researches funds on this podcast all opinions expressed by podcast participants are solely their own opinion and do not reflect the opinion of newfound research. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of newfound research may maintain positions and securities discussed in this podcast for more information is it think newfound.com.
Corey Hoffstein 00:46
In many ways, the topic of conversation for this episode revolves around what ultimately amounts to a fairly vanilla almost index like portfolio. The asset class in question, however, may verge on the exotic for listeners with less fluency in the field of derivatives. My guest is Eric Ervin, President and CEO of reality shares and he is joining me to discuss their flagship ETF Divi. I would argue that Divi is one of the few exposures that truly fits the definition of being both liquid and alternative. By tapping into the OTC market. Eric and his team build a portfolio of one to five year dividend swaps, which have historically earned investors a unique return known as the dividend risk premium. Eric’s confidence to bring such a unique product into the market was born from his experience as an advisor, where he utilized alternatives extensively with his clientele, learning more about this experience and evaluating alternatives and the mental framework he used that allowed him to allocate upwards of 50% of client portfolios is where we begin our conversation. Eric, thank you for joining me today.
Eric Ervin 02:01
Yeah, thanks for having me.
Corey Hoffstein 02:03
And I want to start by saying congratulations. I know new ETF launches are very difficult. I know you guys got your blockchain technology ETF out the door recently and have surpassed the 100 million mark, which is an astounding achievement, or really for any ETF company nowadays.
Eric Ervin 02:17
Yeah, it’s amazing. It took us almost three years to get to 100 million with our other funds and two weeks, we got to 100 million with the blockchain ETF. So that’s pretty exciting.
Corey Hoffstein 02:25
It is very impressive. Not here to talk about cryptocurrency, though as much as it is on the forefront of everyone’s mind. I’ll leave that to other podcasts here to talk about maybe a much more esoteric topic for a lot of people. And really probably one of the very few funds that really does hit all the definitions of liquid alternative, we’re gonna be talking about dividend swaps today, which I know you’re an expert in, and I’m very excited to talk to you about. But before we go down that rabbit hole, I want to actually start with your background, because I know you came into this industry starting as an advisor who made very heavy use of alternatives. So I think your experience is going to be very relatable for our podcast listeners. So I was hoping you could start off with your background in the industry and your experience as an advisor. And what drew you to the alternative space?
Eric Ervin 03:12
Sure, I guess maybe I’ll take it back and work chronologically and how we or I kind of came to a where I am today, but also as an advisor. Some of my different philosophies and investments in being on the West Coast, a lot of the wealth that’s created here is is not capital, markets, wealth, it’s more somebody built a business, somebody built a company structure, somebody was part of a company that sold, maybe they built a big real estate empire. So our clients at Morgan Stanley, I started in the mid 90s, kind of watched the big.com run up and lived through that. But the clients hated the capital markets, why would I want to put all my wealth in the capital markets and modern portfolio theory and for you to tell me that you were down 17% is not a victory. And when the markets down 18 Two, and you don’t get to pound your chest on that, that naturally lent itself to alternative investments and kind of creating an absolute return ish strategy for a client knowing that I would fail years and years out. And the client knew that too. But at least we were trying to make a difference, and to build a portfolio of different kinds of risks in that portfolio. And the clients could understand and so in doing that, you you had this almost like an evolution where you went from first saying, Okay, well, let’s do liquid alternatives. Because they’re different, they can make a difference. But I found, you know, quickly really is, is they’re just high priced T bills and a lot of cases and at the end of the day, they’re either over diversified and shouldn’t really be in a liquid wrapper because maybe the real value was the use of leverage or some other aspect of it or they just had a sexy name, but they didn’t really have a sexy strategy. So really like learning how to dig and I’m naturally I kind of come from an engineering background and have that In my DNA, like I was the kid who took apart the toaster when he was 11 years old. So I just really want to understand things. And so I would tear apart these different strategies and kind of understand where the return would likely come from. And knowing that a lot of them were bogus hedge funds, private equity. Now, there, there was something interesting there, because you could have a lot more interesting strategies, and our clients were a bit wealthier. They weren’t billionaire type clients, but that five to $500 million net worth. And so with that, we were able to use a lot of different unique strategies that had longer lockups and longer liquidity kind of provisions. And again, kind of wanting to understand everything that was in there and really understand the value proposition. It came to how do I allocate my assets to allocate stocks, bonds, alternatives? Or maybe my bond hedge fund isn’t really a bond strategy, and maybe it’s not alternatives? What is alternative? That’s a whole swath of things. So it came down to really what we’re trying to do is just risk reducers and return enhancer. So a bond hedge fund, for example, that’s highly levered, is potentially a return enhancer, not a risk redo, or an equity hedged mutual or hedge fund is maybe a risk reducer and not return an answer. So I can’t think of them like stocks or bonds. And I can now break up the entire planet of investments into these two different buckets. And if I’m right, and sometimes that’s the real trick is being right is, you know, what you think is a risk reducer may not be maybe a risk enhancer and a return reducer. Unfortunately, that is really kind of the premise. And the philosophy that I arrived at made a lot of mistakes. But we would allocate about 50 to 60% of our clients assets in alternatives, by the traditional sense. And to us, it wasn’t wild because it was really just allocating kind of a blended 6040 between return enhancers, reducers wrappers.
Corey Hoffstein 06:54
So you obviously spent a lot of time evaluating the alternative space, which you just mentioned, is really a catch all for everything. That’s your non traditional exposures. And it sounds like your first cut at exploring that space, creating a mental structure around it is that risk reducer return enhancer mentality. But do you have a further mental map for how you go ahead and break down the landscape of alternatives that you’d like to use when you’re thinking and evaluating a new alternative investment,
Eric Ervin 07:22
one of them is to then further to go, and we really, I enjoyed the alternative space, because it was intellectually stimulating. There’s a lot of engagement there and excitement advisor, but also as a storyteller, right? When you’re, when you’re trying to explain to your client, how you you add value, or create value, understanding what the strategies do did. So there’s either strategies or there’s assets. So bonds as an asset, a hedge fund that invests in convertible bonds might be a strategy, or it might just be an asset class, right? We might be just getting ourselves exposed to convert space, or maybe we’re getting ourselves exposed to this manager, and their unique style of managing a portfolio and then that asset, so that was the kind of the next mental breakdown I had to do is, first of all, what are they trying to do? Are they trying to accomplish an objective? That’s a very steady, stable objective? And then second, are they trying to be the alpha generator than a creator of that return? And if so, then how do I put a score on that? And then, if not, then, are they just giving me this unique exposure? Or could I get that exposure myself, again, kind of reverse engineering these these portfolios and strategies, the options market, the derivatives market, there’s a lot of opportunity there for an advisor who has sophisticated clients to do it without the manager. And so that was, again, kind of back to that evolution of that next layer down strategy versus assets. And sometimes both,
Corey Hoffstein 08:48
I think most advisors that I’ve ever spoken to would consider 50 to 60%, to be an astronomical amount, to put a client’s wealth in alternatives, not only because I think obviously, the alternative space is non transparent, and can often be very hard for an advisor to grapple on their own. But because of those client behavioral issues, that their non transparent investment strategies very often and they have a large degree of tracking error to those traditional asset classes, like equities and bonds that they’re going to be familiar with from seeing the s&p 500 reported daily, and then not having that mark, to their portfolio. Can you comment on the way you thought about managing client behavior having such a large allocation to alternatives in your portfolios?
Eric Ervin 09:38
Yeah, it was. It’s interesting, too, because again, it kind of has to be an evolution where then the conviction has to be there. And I think as most advisors, myself included, and you start with 2% allocation, and then you’re left with the riskiest of the alternatives, because otherwise you’re never going to get the payoff. You know, you have to have some massive asymmetry and you start to Get a stigma of alternatives. Those are, those are high risk. But in in reality, if you’re allocating strategies that are designed to produce five to 7%, returns, on average over time with a very low standard deviation, you can’t necessarily allocate just two or 3%. To that, because when the market sells off and your 6040 portfolio blows up, it didn’t help at all. So you have to have a more meaning allocation there. So that’s step one is a what are we trying to do? Are we trying to just be with the market, and if so, then you’re going to be pissed at me when the market blows up, because you say it now that you’re comfortable with that. And yet, when the market does blow up, you’re gonna be upset. But if we’re trying to actually be different than the market, then we have to invest differently. And so that was the first thing is getting on with that. And then the second is, is understanding that these strategies, really understanding them and getting to the bottom of them and knowing who these managers are, and knowing what their risk limit and their leverage limits and all of where is the real return coming from, like merger ARB is a great example. There’s about 357 to 400 deals announced every year, the typical merger or manager will invest in all of them, they’ll earn about 300 basis points have spread on average of that kind of risk that they’re offering. And they’ll lever it up massively, and earn a decent return until it blows up as an overall strategy. There were certain managers who really focused on no leverage finding the deals that are gonna go, and actually shorting the deals that are most likely to break. But the market is not pricing it in because it’s too inefficient. So there were these little opportunities where you could genuinely add value and the clients loved that they loved that you were investing their assets in something that was trying to make a difference. Not always going to win, but at least somewhat understandable and how it worked. And if you could articulate that value to the client. And I think they they worked well for us. In fact, we want a lot of business just in as an advisor. Certainly like investing in Hawaii during the big housing crisis. That was amazing. We were short subprime through a lot of different managers. And that was like the best time ever, I mean, the world was melting down. And we were winning month after month after month. So that was kind of
Corey Hoffstein 12:10
what got you into the, the shorting of the subprime market. It’s fine.
Eric Ervin 12:14
We were just talking about merger ARB. And so there was a manager, John Paulson, who now is very popular and very, very famous that we had a lot of capital with their merger ARB fund. And they had another fun that was a little bit of an event driven arbitrage, but mainly their strategy. And they were that great money manager who could identify which deals were most likely to close, which deals were most likely to break, they had a very good track record. But it wasn’t off the charts. It was just a really solid track record. And we’d been investing with for many years. And about 2006, they started to talk about looking for a way to short housing market. And there’s this subprime comes up and shorting CDOs. And, and maybe in May, I had to go all the way down the rabbit hole, and I learned everything there was I could price a credit default swap, I could genuine I mean, like I was just in love with this as a trade, but also the asymmetry of that potential payoff. And from there, we started to learn an awful lot more about about the asset class, we’ve learned about all the different managers that were trading in the space, we allocated very heavily. I remember calling clients and saying, I know what I’m about to tell you is ridiculous and crazy. But we need to go big on this. And the clients would say you’ve never ever said anything like this, but But wow, okay, you know, if you have that much conviction, and unfortunately paid off quite nicely, but again, it was just kind of the math, it like really all boiled down to the math, you knew the negative payoff was, say 3%. We were buying through Paulson and passport and several of the other funds that we used, were buying credit default swaps on things that we knew were worth zero because we could see the underlying asset, think of it almost like an ETF, you knew what the assets were worth in there. But the ETF imagine if it was trading 100 times more than the value of the assets inside of it. And you could buy a put option on $100. It was just an amazing, really neat time to kind of be in the business.
Corey Hoffstein 14:17
So I want to go back to create some real tangible takeaways here for our advisor listeners to this podcast. Again, going back to the mental map of how you’re navigating the alternative space. There are very common portfolio construction techniques that advisors use a lot of rules of thumb around understanding the breakdown of equities and bonds for individuals, whether it’s outcome focused or just some sort of naive glide path. Again, it’s commonly my experience that people struggle to figure out how to put alternatives in and when they then do put alternatives in the non transparency of the space as well as the complexity of the return profiles, often very nonlinear return profiles makes it very hard to figure out how to use multiple alternatives together. Obviously, you found great success in that and constructing portfolios having as much as 50, or 60%. And alternatives, I was hoping you could expand on your process a little of not only just obviously evaluating these alternatives, but have you thought about building a portfolio of them
Eric Ervin 15:20
back to the return enhancer, and risk reducer, and actually, this is the irony of this all is, as I’m a fairly efficient markets person, I believe that markets are pretty efficient, and money will flow to those opportunities. And those opportunities appear if they’re there. So but you know, that’s over the general long term. So private equity, for example, is like equity is at the end of the day and equity type return, and you’re getting possibly paid for the illiquidity premium, maybe, maybe you’re you’re just getting paid to be able to invest in smaller companies. And so maybe you’re getting that extra return. But a resonated very well with the clients, because the clients in my portfolio were typically business owners. So they appreciate investing in a company, we used to talk about things like insider information is legal and private equity, it’s encouraged, right is to know everything you can about the investment you’re make, versus trying to invest in an opaque space. So we didn’t have these grand expectations for certain aspects of it. But we knew that the behaviors of those products would behave somewhere on that security market line, as a private equity might have a little bit more risk because more concentrated in a certain sector, then you come down that line into say, a an equity long short hedge fund will in theory and equity long short hedge fund that’s not using leverage, that’s a fairly constant, say, long 80 cents and short to 20 cents, or somewhere along that line should have a risk level somewhere around 60%. But he’s like a beta 60% equities. And if it did, then it was a matter of trying to evaluate where the skill level was, but knowing that a good chunk of the returns are going to come from say, 60%, delta to the equity market, and then kind of pricing that in net of fees, and otherwise, and just building that portfolio, again, kind of you’re just working on a, if you start with a 6040 framework for that, that client’s goals and needs, then you just build it out. And so then that 6040 example of let’s say that, that equity manager that say they, we might have put that bucket into, it’s probably 60%, equity, exposure, and 40%. Other and let’s call the other risk reducer. And so now we know we’ve allocated a chunk of that to that. And then there might be other opportunities where it’s completely off, you know, managed futures or something like that. That’s the taster typically for advisors to come in to alternatives with their very first taste. And I think most of the Managed futures strategies are tiny, tiny doses, because A, the fees are so fat, and a lot of those products that they actually create the value that they’re trying to create, and then b It’s a systematic strategy. And so it’s really hard to evaluate when it’s going to work and when it’s not going to work. So we shied away from a lot of those things that they just didn’t fit into the portfolio. So it had to kind of make sense with the EMI trying to reduce risk here this thing, a generally an absolute return style vehicle, or could it conceivably produce an absolute return, then I’ll put that in the risk reducer bucket or the bucket that would have otherwise been bonds, and vice versa. on the equity side, I just use return enhancer style product. So that might be leveraged on a fixed income strategy, that one will be leveraged to anything whacked pretty hard. And so trying to price in those fat tails and diversify those fat tails. So that yeah, if you have one, you don’t have it across the entire portfolio. And that’s really where the nuancing
Corey Hoffstein 18:54
It’s always been my experience that the deeper you dive into a given field, the more intuition you develop around red flags, you’re just very first pass ability to identify as sniff test, if you will, that this this isn’t going to work, whatever it is, and again, alternatives being that broad expanse of an asset class, if we can even call it that, with so many subtle differences between offered products. Are there any rules that stand out for you, or particular red flags that stand out for you when you think about evaluating alternatives that if someone were to simply look for these, it would be a good first pass filter of avoiding a lot of mistakes?
Eric Ervin 19:42
Yeah, it’s a great question and and as I am thinking about it, such as even as you’re asking, I think the first one that came to mind was over diversification. So if you’re seeing like you have to break some rules, if you want to try to outperform so and by rules, I mean, always diversify always Never use leverage, you generally have to like Bill Gates, Warren Buffett, they got wealthy, significantly wealthy by breaking rules they they didn’t sell when they should have, they didn’t diversify, they concentrated in their positions, but it worked for them. And maybe it didn’t work for 99% of the rest of the population. But there has to be some rule breaking. And so in that case, when we see any type of alternative, that’s just hundreds and hundreds of positions across all these different strategy, even if it’s a brilliant macro manager, that’s, you know, taking all these if they’re not willing to take a bet, then oftentimes, you’re going to lose, or you’re just going to pay the fee. Again, it’s that kind of I love that thinking of it’s just a high price, Tebow massive fees over diversified can’t produce out any kind of return, even potentially a return, let alone a return that’s attractive. So that’s one and then the idea of producing something that’s pretty much I can get with just right, if I think a common criticism was to take a manager and look at their returns and really just almost use like, wouldn’t I be better off just levering up the s&p or levering down the s&p cash and s&p? And could I just get a similar exposure to this? So where’s the value? And what you’re, you have to have a great story. But you also have to, I have to believe that the story is there that long, short equity, that’s a really challenging way to make money. There’s, there’s very few managers that can make money on the short side on a regular basis. So why are you short equities? When you just short the SP long? And if that’s the case, why don’t you? Why don’t I just buy an ETF in that regard, but there are managers who have been really, really good.
Corey Hoffstein 21:42
So I want to connect the bridge here, talking about your days, and as an advisor, you’re no longer an advisor, you own an asset management firm with a number of ETFs in the marketplace. Last we were talking about the story, there was the credit crisis, profiting from Paulson as well as making other trades for your clients. What happened post crisis to bring you into the asset management world?
Eric Ervin 22:07
Yes, so that was a great period, and I had a really nice practice. So it was more than 70 years, it was pretty much everything was set. I was always curious, intellectually curious and just stimulated by challenging myself. And the very early days of my career. Actually, I remember I had a great man or he even more like a mentor, he says, You know, I know you’re gonna be okay, I know you’re gonna successful and I just, just remember, don’t make your goal to build a big clients, become a client, figure out, you know, spend the next 20 years just like learn from your clients, your clients are smarter than you are, face it, you know, know it and realize that and learn from them and watch how they create their wealth and watch how they did. And of course, you know, I had this before purge where I could just watch all of these business owners and wealth creators, if you will do that one of them and two of them actually came to him in 2011. Right around that timeframe. One of them had built a very large asset manager, Rochester and sold to Oppenheimer, big muni bond portfolio, about $30 billion of assets. He was the president, Mike Rosen and Charlie silver, and they came to me and wanted to get into the ETF business. And I said, yeah, definitely, we can help you and Morgan Stanley, what are you thinking first strategy? And, and they say, Well, you know, we just want to get into the ETF business, we want to build a company, we haven’t really decided on the strategy. I said, you know, if it was me, I would implement this strategy. I saw a lot of institutions doing that, where you’re basically capturing the kind of growth of dividend expectations overtime, that difference between the actual dividends and the implied dividends. And it was a strategy that again, I saw just reverse engineering, a lot of structure products, seeing the capital markets desk, seeing a lot of what the hedge funds were investing getting as a tool. And I saw with the interest rates as low as they were, with the growth rate of just the overall economy, maybe the stock market was getting ready to sell off, there was a lack of good liquid alternatives. So I saw a real need for you know, my clients could invest in dividend swaps, but but my neighbor couldn’t, and my mom could and so I I just thought it was a wonderful strategy that hadn’t been done yet in ETF space. And next thing I knew I was getting the phone call like you got to quit your job. You got to come start this company and build this product.
Corey Hoffstein 24:22
Eric, I want to start with basics here and build up from there. Can you walk us through what a swap is, then what a dividend swap is and how dividend swaps relate to the Divi portfolio
Eric Ervin 24:35
as swap is nothing more than a financial agreement between two parties. Typically, these are financial institution to institutional investor of swapping an agreed upon asset over time. So over some period of time, there’s interest rate swaps. There’s lots of different types of swaps, but that’s all it is. So you can swap two assets over time. with one another, the dividends swap itself is one of the easier swaps to get your brain around because it’s based on a pretty simple concept. If the dividends per share of an asset, the market stock anything are a number, let’s just say in the case of the s&p 500, which is really where we focus and we see a lot of value, the dividends per share the s&p 500 are approximately $53. Today, and will be this year, we will agree to swap the growth of those dividends, or the decline of those dividends for a fixed value, say $53. So I’m going to set a price with you, you and I are going to agree to pay one year from now the dividend of the s&p 500. And you’re going to pay me 50, or I’m going to pay you 53 And you’re going to pay me either whatever the dividends rise to or whatever the dividends fall to, that’s the floating leg of that swap. So it’s the realized value of dividends. So whatever dividends are realized to be versus the current implied value, which is what you and I agree on as the price those two terms are pretty important with Divi the ETF and the way we manage this strategy, what we do is we allocate and again, with the dividend swaps, you can actually allocate any time between one year two years, three years all the way out 10 years on the s&p 500 What Debbie finds to be the kind of the sweet spot of that is the zero to five year term. And we try to equally wait between 123 and four years. And then we just roll that first year dividend swap on the s&p 500 out every year. So with that kind of equal allocation, the zero to five year time frame, we have this nice portfolio, we invest all the capital that comes in into T bills and use that as the collateral for this dividend swap portfolio. And we ended up with a beta to the market or a kind of an overall standard deviation quite low with a nice decent return but data points.
Corey Hoffstein 27:02
Hey listeners, Cory here, please pardon the interruption. But before we dive deeper into the realm of dividend swaps, I want to try to provide a bit of intuition. Whenever I’m trying to understand a new and complex topic, I often try to start with the limits. For dividend swaps the two obvious extremes are an infinitely length perpetual swap and a bullet one year swap. In the case of the perpetual swap, the floating leg receives all future dividends of the index, which under basic financial theory, the net present value of all those dividends is simply equal to the current index price, which also tells us the value of the fixed leg. Since the index price is equal to the net present value of all future dividends. Any increase in index price implies that future dividends had been underestimated, while any decrease in index price implies that they had been overestimated. Therefore, mark to market value of the swap over time should simply be equal to the difference between the current index price and the index price when the swap was struck. And so the investor holding the floating leg is effectively long the index and all its associated risks and would expect to earn the equity risk premium over time. On the opposite end of the spectrum, we have a bullet one year swap. In this case, the floating leg only bears the risk of the realized dividends accrued over the next year. While the forecast accuracy of realized dividends over a one year horizon is empirically fairly accurate. Investors willing to bear these risks are compensated with what’s called the dividend risk premium. We can use these two extremes to develop a first order approximation of how we would expect intermediate length dividend swaps to behave, we would expect longer swaps to exhibit more equity sensitivity, while shorter duration swaps would exhibit more sensitivity to uncertainty in short term dividends. And with that out of the way back to our regularly scheduled programming error, can you provide some basic intuition around what the dividend risk premium actually is? First of
Eric Ervin 29:06
all, the you know, dividend. Let’s say we both agree dividends are 100. Today, and we both agree, dividends are going to be 110. Next year, we’re brilliant, we’ve got our crystal balls associated with us. And we know dividends are going to be 110. And I want to buy a swap and you want to sell a swap, you’re not going to sell it or I’m not going to buy it from you for 110. Because why wouldn’t I just go buy a T bill for you know, eight or so why would I want to pay 110? For something that’s worth 110? In the future, I wouldn’t do that I would rather put the money in my savings and earn a return on it. So now we know it’s going to be 110 minus whatever the risk free rate is grade. But what if, what if the market what if our crystal ball is a little fuzzy? What if we’re wrong and so then there’s a little bit of risk to that dividend, and maybe it’s not going to be 110 Maybe it’s going to be 105 Maybe a three so now we have to price in that risk. You want to sell because you don’t want Want that dividend risk I want to buy because I believe dividends will be 110. And I’m willing to take a little bit of risk because it doesn’t really correlate with my other assets. And that’s what I’m looking for. And so we arrive at some number, which in the case of the s&p 500, would probably be 104105. So something like the risk free rate plus about a four or 5% total return. And that’s kind of how we arrive at this number. And that four or 5% Return isn’t free, it’s not a free lunch, because there’s risk dividends could fall and I might earn zero, but that’s how dividends get priced in the dividend market. Because we’re a providing a service to the people who don’t think dividends are going to rise or to people who maybe no dividends are going to rise but don’t want the risk on their books if we do have a big sell off because they have so much other risk elsewhere. And so we’re transfer at risk and almost like an insurance, there’s a cost associated with that
Corey Hoffstein 30:55
with the expectation that longer term dividends swaps are going to have much more equity sensitivity and short term dividends, swaps are going to be much more sensitive to immediate uncertainty and short term realized dividends. Can you provide a bit of intuition about how that risk profile changes based upon the length of the dividend swap. So we
Eric Ervin 31:17
have the this equity risk premium on the ultra long kind of infinite portfolio. And shrinking down to some as more things become finite, we have now this kind of dividend risk premium, we’ll call it and it’s not linear. And if you go out to about 10 years, that’s typically where dividends are traded in years. If you go out about 10 years, you’ll find the beta to the equity market is probably about point seven. And actually there’s I should unpack one more thing is there’s the European market where dividend futures and swabs really first kind of were developed. And there’s a lot more literature on that. And so as people are looking around for, they’ll see a lot of information on the European market. And then there’s the US market, and they’re different. In Europe, dividends are much more likely to get cut, there’s no stigma associated with dividend cut in companies pay far more dividend payouts in Europe. And so if your earnings are down, dividends are down and vice versa. So there’s a lot more risk to the dividend market. But as you look across the s&p 500, you find that the beta to the 10 year dividend swap might be about point six. And then as you come in, it’s probably like, point 6.6 point 6.6 down to the six year dividend swap. And that’s when it really starts to tail off because I think we have a lot more visibility of what’s going to happen to Coca Cola over the next five years, or the next 10 year and their dividend payments. And certainly as we come in the 12 months, we have perfect visibility on what those dividends and Coca Cola as an example. Now, what you’re talking about is like an estimation value, and then a market pricing value. And and that is why we call it the dividend risk premium, which is kind of what’s the risk I’m taking? Or what’s the risk I’m requiring what’s the payment return on requiring to invest in this shorter market structure, it’s about point three or so I would say on those, we try to focus on the zero to five year band. And what we find is about point overall beta or delta and correlation to the s&p 500.
Corey Hoffstein 33:16
With that sort of zero to five year portfolio, you’re coming down the risk spectrum avoiding that more equity like risk focusing more on that dividend risk premium. Can you talk high level expectations for historically what that premium has looked like the sort of volatility associated with that premium? I think probably most interesting for people when they start to evaluate a new unknown asset class is thinking through the level of potential drawdown but really, what is the catastrophe risk look like for this type of portfolio that is truly a risk premium and you’re bearing a risk to earn a premium. How does that risk materialize? And what does it coincide with with other market risks?
Eric Ervin 33:58
Yeah, and it’s a little bit dynamic too, because if the s&p 500 Let’s just talk about the dividends it what’s the risk that dividends? How do they behave? Because I think that that’s first important, and then we’ll unpack it to how does the market for dividends swaps behave? The s&p 500 has increased its dividend every year except for three over the last 45 years. So there’s only been three down years, two of them were in the 2000 doesn’t one and single digit have five, six, and then the one, the big daddy was in 2008. And that was about 20 20% decline, depending on which index your look, but this are the dividends of the s&p 500 declined around and just to kind of really, like zoom in. So we had a third of the s&p was in Financials, they were the single largest payer and they didn’t cut, they eliminated they completely wiped out their dividend, right. And still, we had only 18 declines and of the s&p 500 that year because Coca Cola you know, a lot of companies continue to increase their dividends throughout. In fact, the info tech companies started to really come in and be big payers throughout that, that time, as more and more companies wanted buoy their lagging stock price. So very, very unique risk event, right. And that was the first and only time we saw a double digit decline in the s&p 500. So you could consider that the mega fat tail, right, and there’s the risk is picking up pennies in front of this potential bulldozer. But how often does that bulldozer happen? Well, it didn’t happen very often, most of the time, the average return is around six and a half percent growth. And you can kind of almost think about this, like earnings growth rate is it should be somewhere on the line with earnings growth, which should be somewhere on the line with kind of overall productivity growth. That’s so in most environments, you’re gonna get a typical kind of growth path, the standard deviation of that six and a half percent is around six and a half percent. So we’re earning dividend growth at six and a half percent, and we’re only paying the risk of six and a half percent. Not bad, right? That’s the real dividend market. But markets are smart, and they’re gonna price some of that in. And so what we found in this zero to five year dividend swap portfolio range, you’re gonna earn around, and obviously, this changes over time, but But around three to 5%. So you’re going to be, on average, the market is going to price in like one to two, when the dividends are expected to grow. And so you’re only earning that three to five of the dividend growth, but you’re also earning everything on your cash. So you’re earning the risk free rate plus the three to five. And so as interest rates continue to rise, interest rates rise, you’re earning that cash return plus this risk premium is that three to 5%, on average, most of the time.
Corey Hoffstein 36:46
So in reading a lot of the literature that is out there around dividends, swaps, even a year and a half out, when there’s a large degree of certainty around what dividends, you should actually realize these dividend swaps do tend to still trade at a economically large discount. And there’s this whole pull to realize the fact that as you march closer and closer to the final termination date of the swap that you actually get to the appropriate value, I want to spend some time exploring why that exists, we continue to call it a dividend risk premium, which implies that it is truly a risk you’re taking on and you’re acting somewhat as an insurer to the volatility, and perhaps it’s the negative skew of dividends. But it has been proposed in the literature that this might actually be due to behavioral effects, it may actually be a structural bias in the market, a supply and demand issue created by structured products being issued by banks. And then there is obviously the risk argument, I was hoping you could explore that a bit for us and go over some of the arguments as to not only why this has existed, but why we should expect this premium to continue to exist.
Eric Ervin 38:00
Okay. So to do this properly, what we first need to do is take a step back and look at what’s happening in the derivatives market, all derivatives based on the future price of an instrument. So, options, put options, call options, futures contracts, forward contracts, anything that’s based on the future price of an instrument is predominantly driven by one thing, which is the price of that instrument. And that’s what we all know. And that’s what most of us think about whenever we’re trading or investing in that vehicle. But it’s also based on two other things. One is interest rate risk, which is very easy to hedge. And then this third thing, which is very difficult to hedge, if not impossible to hedge without dividend swaps is the dividend risk. Because if you think about when stocks pay dividends, they’re constantly going ex dividend. And if you’re entitled to the future price of those stocks or that index, then you’re entitled to everything except for the dividends that are going to be paid between now and that future period. So like it or not, you’re accepting a dividend risk in that investment. Now, that doesn’t matter it for the vast majority of people who are investing in that marketplace because again, they’re looking for the price action and the price momentum of that stock or security or call option, etcetera, that underlying asset, but for those who are taking the other side of that transaction and trying to offer that so such as investment banks and capital markets desks, it means a lot because that small little piece, that dividend piece, if it’s unhedged leaves them with a dirty hedge or a dirty exposure. And that’s all fine and good as long as they aren’t putting too much capital to work. But as that capital grows and grows and grows, they need to get rid of that risk. And so that’s why they created the dividend swap market so they could offer that risk or offset that risk by selling that off. Do pensions and endowments and other hedge fund environment. And really that was the start of the dividend swap market was to complete that triangle of spot price, future price, interest rates, which we already had. And then finally, the dividend in the middle, which was that that dividend swap really completes that triangle and creates a perfectly hedged forward transaction. So now fast forward to structured product issuance, or any other issuance where companies or investment banks are issuing something that offers you the upside, for example, up to a certain point of the market without any downside or with some limited downside, what they’re doing is they’re going in and entering into forward transactions. And in order to properly stay in that business, they need to hedge out some of those risks. And so they do that by selling dividend swaps into the market, creating a supply, which is pretty structural in nature, because again, they’re in the business of issuing instruments and hedges and forward transactions on the market as a whole on the price of the market. And then these dividends become kind of the byproduct or the scraps on the factory room floor, that they’re willing to sell off, in order to continue their main line of business, which is creating structured products on the market as a whole, it’s estimated that some $270 billion of structured products are issued every year, just in Europe alone on the market and the price of the market, that leaves these banks with, again, a very small fraction of that in terms of dividend risk, the fees generated on that $270 billion are far in excess of whatever haircut that they’d be willing to take on their dividend risk. And again, that goes back to just the gross notional size of the structure product issuance versus the small notional size of the dividends swap or the dividend risk that they need to hedge in order to do more structured products. And that’s kind of how we can enter this oversupply of dividends swaps, which is a relatively small market, versus the massive demand for structure product issuance, which can create this kind of supply demand imbalance in the dividend swap market. It’s good for for investors, obviously, and you know, we believe it will continue far into the future. And even when it doesn’t, again, you still have this, there is a risk to owning dividends. And so so there will still be demand to sell off that risk, again, for the offset of fat tail event or other things like that. So So we believe it’s persistent and it will likely continue into the far, far future.
Corey Hoffstein 42:35
Can you address the argument that dividend growth expectations should be lower going forward due to the role that increasing role that buybacks are playing in the marketplace?
Eric Ervin 42:44
This is a great one. And it’s actually it defies a lot. I mean, this, you know, the dividends versus buybacks? Should we really be paying out dividends and paying taxes on them and forcing other people to pay taxes on them? And yet we do just societally, it’s the way we do and have done things. There’s a lot of merit to it, even in 80s when we saw tax rates in some states as high as 85%. We still saw dividends and dividend growth. I mentioned, dividends have risen every single year, except for three, even when we had massive buyback regime, or kind of all those different regimes. But say in the 90 like late 90s, when if you were paying a dividend you were you were an old fuddy duddy and deserve to to get any capital, right and to be changing your name to.com. and forgetting about cash flows that market even we saw dividend growth and the s&p 500 But it was a lot more muted. It was like two to three. So even with a big buyback regime, we could still see pretty significant growth to put some numbers to it. If you think on average, let’s say right now we’re at a 50% buyback 50% growth or dividend payment, on average kinda it’d be 500. If we go to a 60% buyback, 40 If it happens tomorrow, then we’re going to see dividend cuts, if it happens over time as earnings are growing, which is generally what we’re seeing is those buybacks start to expand, they have to take over more of the cash flows, the dividend rising, they’re just maybe not rising as it could. And then we see earnings cut. This is the nice thing basically see the buybacks get cut, the dividends are stable, and that’s really what we’ve suffered time we have a model to predict dividend growth and actually buy back to dividend ratio it or to that, because buybacks, yes, you kind of have two bullets in the gun at that point. And if there’s a problem on the horizon, a CEO or an executive or board of directors, you can always just cut the buybacks they’ll know versus if you got that dividend, you know, taken out and shot.
Corey Hoffstein 44:40
Can you explore for me this idea that it’s not actually the level of the dividends that matter so much as what the expected growth rate is. And to that point, it doesn’t matter whether we expect dividends necessarily to grow by 5% 1% or even if everyone believes If dividends are gonna get cut for the next five years and grow by negative 3%, that there could still be a premium that can be earned around that expectation.
Eric Ervin 45:09
Yeah, this is a nuanced point, it’s good that you bring this up, because it’s, it’s really important for the asset. And this is why I consider this to be more of an absolute return strategy. And it’s agnostic to a lot of those different environments. Again, kind of hypothetically, say, we have our crystal ball, and we know dividends are gonna fall 10%. And I still want to do the dividend swap with you, I still want to invest you want to sell because I want to get rid of the risk for some reason, because so you can do more structured products, because your boss is telling you, you can’t do anymore. So you need to get rid of the risk. So let’s come together and agree on a price. Well, we’re not going to pay 90, I’m not going to pay you a night because I could rather buy a T bill. And so I’m something less than that. And just in case, my crystal ball is a little fuzzy, I’ll give you 87. And you’ll say okay, well, I really need to do this structure product, and I’m gonna get the dividend anyway. So why not? There’s very little risk, right? So you trade for 87. And now I’m actually able to earn the difference. And so I’m earning that to 5%. You know, over time, that different risk premium, even though dividends fell 10%. In that example, they went from 100 to 90, we traded at 87, which ended at 90, I’m happy you’re happy, you know, you you were protected. And that’s really how that marketplace kind of exists in that regard on a regular basis. Now, had you already been an investor yesterday, and now dividends hadn’t hypothetically gone down, then obviously, there’s going to be an adjustment period, right? Where now all of a sudden, the expectations are negative 10%. Add in the premium. And now we said again, earning that premium that dividend risk.
Corey Hoffstein 46:47
So is it fair to say that structural shifts in dividend growth expectations, so long as they’re well forecasted or even cyclical shifts, so long as they’re well forecasted? shouldn’t affect your ability to necessarily earn a premium, it’s more, you’re susceptible to sudden changes in expectations?
Eric Ervin 47:07
That’s exactly right. In the market, you know, because it’s a longer market, you can, you know, we’re going out five, five years, but still, it’s fairly, fairly short term, the market is pricing and more risk of something like that out five years than it is in one year. So we have some of that priced in. And then if there’s just this, all of a sudden, there’s maybe a new regime, this one, I think, you know, pretty practical. And so I’m always thinking about, well, what’s the catch? Come on, there’s got to be so a tax regime where they say, from now on dividends are taxed at 100%. That would be a very bad thing for a product like this, or an asset class like this, because now companies are going to really have to rethink their overall dividend policy, I don’t think they cut it to zero because there’s still that Endowment Foundation type investors that care about the dip in the cash flow. But now dividends get cut, let’s say 10%, across the board. And so you’d see day tomorrow, just drop 10% across the board, and then go back to that risk premium.
Corey Hoffstein 48:05
I want to pit you against you for a second here. You mentioned when you evaluate alternatives, you sort of think to yourself, what’s the beta? And why not just invest in some sort of de levered s&p. So you mentioned the zero to five year dividend swap portfolio, you can expect a market beta of about point three. So I guess my question for you would be why shouldn’t I just take 70% of my portfolio, hold it in T bills? 30% Hold it in the s&p, I’ve got far more transparency. I understand the market. I don’t have to deal with Counterparty Risk. Why is the juice worth the squeeze?
Eric Ervin 48:37
Yeah, it’s, it’s the question I would ask myself. So it’s perfect. It’s different dividends? I mean, that yes, they have the beta, but they’re also different. And I can justify the differences. I mean, I was literally that kid in class, who would ask, Well, why What do you mean mc squared? What if it’s MC cubed are to the end, the teachers would get so frustrated? So I love to ask this. Why, why why, why, why until I can finally get to. Okay, that makes sense. I can justify that. And if it hasn’t been of point three, because markets as they rise, dividends also rise. So the two things work together. That’s kind of like more toys are sold in colder climates, not because it always gets sold in colder classes because Christmas is in a colder time of the right so there is some definite correlation for sure. But it’s not necessarily causation. So as we get sell offs and markets, which is really what you should be most concerned about when you don’t want them to correlate does the sell off really impact Coca Cola is dividend policy is the Board of Directors saying geez, the markets going down today? Maybe we should cut our dividend. I think it’s actually the opposite. So we see that most of the time we’re seeing kind of rising dividends on a steady basis. As markets are just going through little hiccups. There’s no change and the dividend policy of most of the s&p 500 ish companies. So we see a good stability and stick unis to the downside. And then we just had that kind of one period where where we saw these massive declines, so then you just have to evaluate. Okay, so we’re definitely going to have some correlation to the downside there. And had I bought the 30% equity market 70 for T bills, I would have probably had a pretty similar return profile had I just been invested in the or the dividend swap market. So it kind of works along each of those different, like points along the way. And you kind of get the correlation when you want it and the non correlation when you don’t want it.
Corey Hoffstein 50:33
So I want to put you back in your shoes as an advisor. And we’re gonna pretend for a moment that I am a wholesaler. And I’ve come to you and I’m trying to pitch you Divi and your back in your days as an advisor using 50 to 60% alternatives in your portfolio. Talk to me about how you would go about evaluating a product like this, what’s your framework for due diligence? And maybe then assuming clearly, because you are biased, and we know ultimately how you’re going to land on this, assuming you are going to put it into your portfolio? How do you think about it in that bifurcation of risk reducers versus return enhancers and thinking about incorporating it in a client’s portfolio.
Eric Ervin 51:13
First of all, the risk reducer concept anytime you get into risk reducer land, you have a far larger burden of proof that that you have to do as you know, as a wholesaler or as a product or something, right? Because because now you’re asking me to add a lot more money to this strategy, this oddball esoteric strategy that I don’t know much about. And so I really need to do a lot more research on it. If it’s a return enhancer, I can allocate a much smaller amount and still get the benefit. If I’m right. It’s the strategy. So now I have to do a lot more work. So is there leverage in this risk reducer strategy? That’s a big question. In this case, we wanted to check that box no and and effectively does, because oftentimes, we do the risk reducer strategy that come to us are, are using leverage in some way, shape, or form. And you really have to understand the portfolio and what you’re leveraging. And then what’s the timeframe. So here we don’t have a big time TVs, I mean, it’s been around for a while now. So we’ve had time to bake it and really see in market real dollars being allocated and redemptions creations, we’ve had all these different environments, we’ve had the Brexit, you know, we had, we got to watch it. And so now that’s, that’s a blessing in on day one, it was a much more difficult product to understand your brain around and get to see a trade. So now at least we have some history, but it’s not a huge history. So then the next step is okay, now how do we go? The next layer down and understanding these dividends? And really where they trade, how they trade? How often they trade? Who is the buyer on the other side? And vice versa? Who’s the seller? And when does everything go wonky? Right? When does it all go sideways? And so what’s going to cause those buyers and sellers to break down their traditional relationship of kind of this value proposition for us. So I think of it you know, kind of in those factor and then obviously, the fundamental of core of what do I think dividends are going to do. So if they’re right if this wholesalers right, and he’s telling me that this product is built and designed to be based on that dividend payment stream, somehow some way shape or form, then I can generally come up with my own assessment, I think dividends are going to do that’s a there’s a lot of good information out there. And we have a pretty robust set of research and on our websites, both the advisors website as well as the ETF website. But if I can get comfortable with the dividends, and I can understand, okay, the s&p Dividends are probably going fairly continue to grow as then I need to understand these the trading environment and how that happens. Fortunately, now the futures trades, so anyone Internet browser can go to this news website and see where these dividend futures are priced and trading. That’s great, we get a lot more transparency now than ever started the product or a few years ago, instead of the over the counter market, because they do really trade almost very so. So that’s good check that box not using leverage continue, you know, like it’s investing in an asset that I can kind of understand now it’s a matter of where does it go sideways? How do these two market presents that have generally been stepping together day after day after day, because one person needs to sell the risk and the other person needs to buy one or they change their mind? And that is going to be one when there’s huge structural overhang, right, which is going to cause kind of a reset, which is going to be a fantastic opportunity. And I’m going to want to know it that that it’s an opportunity and not a breakdown of some fundamental thing. How do I get that information? Right? Because is the firm big enough to call me? Probably not. And so are they big enough to answer the phone when I want to talk to this structural or is this is this a mispricing or an anomaly and then just kind of understanding a little bit more about the market and that’s really what I see of this as a product is it’s going to have shifts there’s going to be moments when markets reprice things we’ve even seen it just been alive in February of 2016. I think it was when we saw kind of this Like shift in the curve, yet no shift and dictations for analyst seconds, no shift in expectation the economy and like that, and yet we saw the kind of flattened, so that was one of those great opportunities to enter and buy kind of like a good entry, but then those are really few and far between in about three years. So for the most part, it’s type of a product. And I think, you know, you start allocating, but you just, you have to allocate a more meaningful amount. And this is what I would say, and I would argue myself is I have to allocate more meaning that otherwise, I’m just messing around, you know, it’s, and I encourage, you know, usually people to mess around and try it and start to see and watch it it used to it before they allocate bigger dollars to something like a risk reducer. But at the end of the day, you have to, we’ve done a lot of work on, say, a 5050 bond bond for like bond type allocation. And it’s pretty amazing how I think that the Ag had a standard deviation of around very low standard Divi has stand for so very low, like both of them, when you put them together. I think this deviation went to 2.5. Just to sum I mean, that’s like, like, that’s how portfolio allocation is supposed to work. And if you can do that with these kinds of assets, anything it’s so last
Corey Hoffstein 56:11
question for you. This is my question that I’m asking everyone. And it is, if you were an investment strategy, any investment strategy, you could be market beta, you could be momentum equity, you could be merger arbitrage. What strategy would you be? So what strategy sort of, are you the personification of and why?
Eric Ervin 56:31
That’s a cool question. Let’s think you’re a lower vol strategy to be sure it’s funny. It’s in the DNA and a bit more esoteric. So I love arbitrage. I just, it’s math right? It just comes down to math and you can identify it. So like a market neutral arbitrage oriented strategy is probably right up my alley, I think identifying inefficiencies and capturing with math. That’s probably the most elegant.
Corey Hoffstein 57:02
Eric, it’s been a lot of fun. Thanks for joining me.
Eric Ervin 57:04
Corey Hoffstein 57:08
Thank you for listening to my conversation with Eric Ervin. You can learn more about Eric and reality shares at reality shares.com Show Notes for this episode are available at flirting with models.com/podcast. If you enjoyed the conversation, I’d urge you to share the podcast with friends or on social media and leave us a review on iTunes.