VEGA: 3rd Quarter 2020 Portfolio Manager Review
Performance data quoted represents past performance and is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than original cost. Returns less than one year are not annualized. For the fund’s most recent standardized and month-end performance, please click www.advisorshares.com/etfs/vega.
|MSCI AC World Index||-2.43%||5.83%|
|Cboe S&P 500 Buy Write Index (BXM)||-0.02%||-9.58%|
|Bloomberg Barclays U.S. Aggregate Bond Index (AGG)||-0.05%||6.79%|
As of 9.30.2020.
September stuck true to its historical roots and volatility reappeared as soon as the calendar page turned. The market continued to trend down until late September and then began its march back upward.
The bright spots in September was low duration mortgages, represented by LMBS in the VEGA portfolio. LBMS had a positive return of .12%. The other positive returns came from the Protective Puts added back in August 2020. Read out in the Activity section to find out more about the Protective Puts.
The September appears to be an inverse to August in terms of top performers. Consumer Communications (XLC), Technology (XLK) and S&P 500 (SPY) had the worst performance with returns of -5.90%, -5.34% and -3.74%, respectively.
|Ticker||Security Description||Portfolio Weight %|
|SPY||SPDR S&P 500 ETF TRUST||52.11%|
|EFA||ISHARES MSCI EAFE ETF||5.20%|
|XLV||HEALTH CARE SELECT SECTOR||5.01%|
|BLACKROCK LIQUIDITY T 60||4.92%|
|XLK||TECHNOLOGY SELECT SECT SPDR||4.83%|
|XLC||COMM SERV SELECT SECTOR SPDR||3.86%|
|IGSB||ISHARES SHORT-TERM CORPORATE||3.67%|
|MINT||PIMCO ENHANCED SHORT MATURIT||3.63%|
|AGG||ISHARES CORE U.S. AGGREGATE||3.62%|
|JPST||JPMORGAN ULTRA-SHORT INCOME||3.62%|
As of 9.30.2020.
August Covered Call Writing was a text book example of what happens when the market rises to the strike of the Covered Call. September was a good example of what happens when the market draws down after a Covered Call is sold. Near the end of August VEGA sold a Covered Call for September expiration with a strike of 357, when the SPY was approximately priced at 346. After the Covered Calls were initiated the market continued to rise until September 2nd, hitting its high of almost 359. However, fter making new highs the SPY tumbled through September expiration. This makes for a good example because VEGA was better off having sold the Covered Call that having just been long during this period. Had VEGA gone long only it would have suffered performance decline of approximately 4.34%.
However, since VEGA sold the Covered Calls the strategy was about $.60 better off that had the positions just been held long. This is because VEGA sold 60% coverage on the Covered Calls and earned about a $1 per contract.
(SPY Price At September Expiration – SPY Price At August Expiration + Option Premium) / SPY Price At August Expiration
(331 – 346 + .60) / 346 = -4.16%
While both numbers are show a decline, having sold the Covered Calls VEGA was better off. It may not appear to be dramatic the good thing about the VEGA is the consistency of the strategy. VEGA will continue to sell Covered Calls in declining markets every buffering the decline. In most cases of declining markets the more dramatic the decline of the market, the more rich the option premium becomes. Meaning what was $.60 could increase buffering the decline still more.
Protective Puts could not have made a re-entrance into the portfolio at a more opportune time back in August. Nearly as soon as VEGA add the Protective Puts back to the portfolio did the market decline. The Protective Puts were added to the portfolio back in August and were purchased for a price of $4.10. In September when the market was experiencing a decline the Protective Puts increased by over 10% to over $4.50. This is important to note because the market fell approximately 4%, but the Protective Puts increased by over 10%. Showing the asymmetrical relationship between the market decline and an increase in option prices. Now if one were to examine the Protective Puts from August 26th, the date of the SPY example the Protective Puts actually increased by 90%, because the Protective Puts had lost value since they were added and were priced at $2.34 on August 26th. The asymmetrical pricing mechanism during a high volatility environment could prove to be beneficial to the strategy given the U.S. is entering a very contentious election period.
Volatility-Based Reinvestment (VBR) is a systematic way to deploying cash accumulated from the selling of Covered Calls or Strategic Cash back into the market when the market is trending lower. Having deployed 6 rounds of VBR in early 2020 the VIX would need to be significantly above its 200-day moving average before ash cash be reinvested. The 200-day trended upward to 25 at the start of September. Although the daily VIX has trended lower between March and September, the 200-day average continues to rise. This is because the large spike in early 2020 is now a major component of the average and the previously low VIX data points are dropping out of the average. VEGA would still need a VIX of at least 60 before deploying any additional cash.
VEGA continues to look for opportunities for Tactical Shifts. VEGA is currently satisfied with its current exposure to the global. As more information comes to light about the U.S. elections, potential vaccine and other confluences of world events, there could be opportunities for tactical shifts in late 2020 or early 2021. However, until more details are known, a concrete idea what those shifts would be is unattainable.
When the new calls were sold against the S&P 500 in the beginning of August the beta of the portfolio was at .65. This is just slightly above our historical target beta of .60. VEGA will look for opportunities to potentially add more Protective Puts between now and November. However, given the there may be volatility during the election process the expectation should be the Beta may rise slightly in the case of a Volatility-Based Reinvestment.
Fixed Income continues to maintain a relatively low duration of 2.31, which is up slightly due to the changes in the underlying Fixed Income ETFs. VEGA continues to think that low duration is prudent give the market environment. Should more volatility return in late 2020 or early 2021, principle values of high duration Fixed Income positions will be impacted more than their lower duration counterparts.
With the end of the third quarter, we felt it important to take a step back from the day-to-day market swings, analyze the fundamentals, and break down what this implies for the near-term future. This review will summarize what happened in the third quarter of 2020 in a compact, high-level manner and then transition into what we think could be in the cards for the fourth quarter and beyond. We utilize a top-down approach, beginning with a broad overview of where major global economies stand and where they could be heading before progressing towards more market specific data and views. We will then end with our interpretation of the available data and our expectations of the trajectory of markets and the economy.
As we reflect on the year thus far, there are a myriad of words one could use to describe the events of 2020. In our view, the word that best summarizes the year is “unprecedented”. From the spread of the coronavirus to the fiscal and monetary response seen around the world, we sincerely hope we see nothing like 2020 again. To make matters more interesting, as more administration officials test positive for the novel coronavirus, the United States still faces a contentious election in just a few weeks that could chart a new policy path for years to come. The events of 2020 have made the dismal science of economics quite literally dismal, and economists and analysts—including our own—have had an extremely difficult time forecasting where we go from here. In just the last several weeks, top institutions such as the Organization for Economic Co-operation (OECD), Morgan Stanley, and Goldman Sachs revised previous outlooks in a mixed direction. While we do not prescribe to all of their conclusions, we highlight these examples to remind you of what a complex and ever-changing world we live in. With this caveat in mind, the Partnervest STAR Spectrum Investment Committee submits our fourth quarter and early 2021 preview to you, our clients.
In our view, amidst all the COVID-chaos and a very contentious election season, there are three things that matter most for global economies and markets:
- The size and scope of additional fiscal stimulus
- The behavior of the consumer, driven largely by consumer confidence and the labor market
- The timing, distribution, and efficacy of a COVID vaccine
To begin our outlook we look first to the OECD which recently went against the bearish revisionist trend by updating their global economic outlook upwards. In their report, “OECD Interim Economic Assessment, Coronavirus: Living with Uncertainty” the economic bloc revises their previously released June economic outlook to reflect what they identify as “the prompt and effective policy support introduced in all economies” which caused a faster than anticipated recovery from second quarter lows. Their projections assume a couple of key factors to keep in mind: sporadic local outbreaks will continue and will be addressed by targeted local interventions (not national lockdowns), and vaccination will not be widely available until late 2021.
In aggregate the OECD revised the Global GDP growth rate for 2020 up 1.5% to an annual decline of 4.5% at year-end 2020. Acknowledging more of the recovery took place in 2020 than previously anticipated, they also revised their 2021 GDP growth rate down slightly to a 5% expansion. While overall bullish news for the future economic trajectory of the world, there are considerable differences to their revisions on a national basis. Focusing on economies which account for the largest changes to the predicted global GDP growth rate, we saw upwards revisions to GDP estimates in China, the United States, and Europe, while there were downwards revisions to India, Mexico, and South America. While these changes in-part reflect the nations’ relative success in slowing the spread of the novel coronavirus, it is also important to consider where each nation’s economy was at the end of 2019 before entering the global pandemic. In most economies, the level of output at the end of 2021 is projected to remain below 2019 levels. Amongst countries with monthly economy-wide estimates of economic activity, a little over one-half of the declines in output between January and April 2020 had been restored by July, indicating that the recovery has both momentum and capacity to continue in the near-future.
In this day and age it is impossible to discuss economic recoveries without paying keen attention to the fiscal and monetary support making them possible. By May 2020, job retention programs supported approximately 50 million jobs across OECD countries, which is around 10 times greater than during the Great Financial Crisis. Analysts from all industries and nations stress that this and other accommodative measures must be maintained to boost confidence and reduce uncertainty, two measures key to a long-lasting recovery. So far it appears monetary authorities have heeded these calls as central banks have continued to announce further policy easing since the start of June. There have been enhanced asset purchase and funding programs in Australia, the EU, the UK, and the U.S. while there was a further lowering of interest rates in Brazil, Indonesia, Mexico, Russia, and South Africa. Lastly, the U.S. Federal Reserve recently adopted an average inflation target, assuring accommodative policy measures well into 2023.
Domestic Economy Outlook
We begin our discussion on the future path of the domestic economy with recent estimates released from the U.S. Federal Reserve. In a similar note to the OECD’s September revisions, the Fed’s Board of Governors released updated projections which allude to a faster recovery taking place in 2020. Noting such trends as household spending having recovered about 75% of its earlier declines and numerous other leading indicators such as the robust housing market, the Fed revised their 2020 U.S. GDP growth rate up 2.8% to an annual decline of 3.7%, followed by a 2021 GDP growth rate of 4%. Furthermore, they revised their projected unemployment rate for year-end 2020 down nearly 2% to a projected unemployment rate of 7.6%, followed by a 2021 unemployment rate of 5.5%. While these bullish revisions reflect a greater-than-anticipated absorption of the simulative fiscal and monetary policies present, they come at a cost. Partially reflecting this and the newly adopted average inflation target, the Fed revised their estimate for Core Personal Consumption Expenditure (PCE) inflation up 0.5% to 1.5% at the end of 2020.
Turning now to more concentrated analysis, we bring to light the relatively bearish report recently released from Morgan Stanley entitled “Testing the Resilience of the Recovery”, in which they acknowledge the harsh reality of recent political events. Following the passing of Supreme Court Justice Ruth Bader Ginsburg, it is now widely anticipated that an additional COVID-related stimulus package (CARES 2) will not appear until after the election, and many fear not until early 2021. Reflecting the importance of fiscal stimulative measures during this unprecedented demand-shock, Morgan Stanley joined numerous other banks in revising their projected 2020 GDP growth rates downwards. What was set to be an annualized growth rate of 9.4% in the fourth quarter now stands at an estimate of just 3.5%, lowering the anticipated 2020 growth rate from a decline of 3.4% to a decline of 3.6% year-over-year.
This anticipated “fiscal constraint” all but assures a marked deceleration in fourth quarter growth in our opinion. Following an astonishing estimated 33.2% annualized GDP growth rate in the third quarter, the resilience of this recovery will no doubt be tested in the coming months and heading into 2021 as consumers are now more or less left to rely on economic reopenings and positive COVID-related developments to further spur economic activity.
Focusing on the consumer, we note the evident dent in aggregate income due to the expiration of supplemental unemployment benefits in the amount of $600 per week. While we believe this to be a serious headwind for future recovery, the initial CARES Act is still seen to be providing some margin of support to the household sector in the form of a savings buffer. With spending subdued and incomes remaining well above trend since April, there is evidence that savings has accrued to households across the income spectrum. So, while this dip in aggregate income is undeniable, there was not the sharp drop-off in spending most expected because households were able to smooth out their consumption as they began to dissave—a dynamic we expect to continue in the coming months. This so-called savings buffer likely supported the positive retail sales growth present in August and September, which accelerated PCE to 95.4% of its pre-COVID level.
Turning to the labor market, we expect the gradual recovery from the 22 million jobs lost between March and April to continue as leading indicators such as the housing sector and shipments/orders for durable goods all rose above pre-COVID levels. As of the end of September, nearly 12 million jobs had been recovered as the nation continues to reopen, a particularly bullish statistic considering most estimates as compiled by Morgan Stanley had forecasted only 40% of lost jobs would be recovered by the end of 2020. Looking forward to the end of 2020, analysts expect job growth to average around 790,000 jobs per month and around 475,000 jobs per month at the beginning of 2021. If accurate, these trends would be enough to push the unemployment rate to 7.6% at the end of 2020 and 5.5% in 2021, consistent with the Federal Reserve’s labor projections. This is a particularly important trend considering that while unemployment benefits will be markedly lower with the absence of CARES 2 for the foreseeable future, gains to labor income are anticipated to “pick-up” this fiscal slack.
To conclude the domestic economy outlook, while there are sufficient gains from the economic recovery to-date, and many believe there is sufficient momentum and resilience in underlying economic activity to sustain the recovery in the coming months, we believe there are two key risks to consider carefully. Most importantly is the spread of COVID-19. If another wave sweeps through the U.S. and forces businesses to close and consumers to stay home, there will likely be serious negative consequences to future recovery prospects. Secondly, while consumers are anticipated to benefit from the savings buffer noted above, state and local governments do not enjoy such protection. As state and local governments represent roughly 13% of total U.S. payroll according to the Bureau of Labor Statistics, the absence of much-needed financial support due to “fiscal constraint” could lead to widespread reductions in state and local spending, which we believe would ultimately cause a serious drag on the labor market recovery.
Domestic Market Outlook
The accommodative policies established worldwide and highlighted above have created a particularly “hungry” market, as individual and institutional investors search widely for the yield they once enjoyed. This facet alone has created tremendous volatility and spikes in trading volume which should be expected to continue through the end of the year. The upcoming election and daily COVID updates, either vaccine or transmission related, will only serve as a catalyst to this already present trend. Moral of the story: Buckle Up.
While this outlook will make no attempt to predict the course of the next election due to its historic nature, the equity market and its decades of history make it a different story. Though it may feel two candidates have never been further apart in terms of policy direction and focus, we remind the reader of America’s “Politics of Moderation”. Campaign promises and sound-bites on the path to election serve as one thing – an indication. Though helpful, these indicators hardly ever prove to be 100% accurate when the candidate becomes President and his promises are met with the bureaucracy, compromise, and lobbying which has molded the course of politics since the founding of the country. Just remember how intent the Republican Party was several years ago on repealing and replacing the Affordable Care Act, better known as Obamacare. Historically, elections have little to no long-term bearing on equity performance simply because who is leading the country matters little compared to what is driving the market. While the separation between these two fields has become increasingly blurred in recent history, the implications of it reign true in our opinion, now more than ever.
To address the elephant in the room, the main driver everyone is looking at is of course the development, approval, and distribution of a COVID vaccine. This will be a key driving force for the market as a whole, and sectors at the epicenter of the pandemic such as the travel, leisure, and select retailers. We do note the anticipatory nature of the markets and the ongoing search for yield mean that many “popular” scenarios are already priced in. However, this does not mean past market trends are not positioned to continue.
Firstly, we look at credit markets. To date, there has been a record amount of issuance in the fixed income market with over $2 trillion in issuance amongst both the investment grade and high yield portions of the market according to a recent Financial Times publication. While the majority of the funds raised in this market went to providing liquidity for cash-crunched companies during the first half of the year, recent months’ supply represents issuers taking advantage of record low rates to address upcoming maturities and liability management. This is a trend we expect to continue into 2021 despite the record amount of issuance taking place, as spreads have remained in a steady range. This alludes to our belief that supply is simply following investor demand, itself spurred by the “chase for yield” phenomenon we’ve all become accustomed to. As shown through mutual fund flows and overseas valuation metrics, the demand for U.S. investment grade credit remains strong and the Federal Reserve is a key player in this conclusion. Earlier in the crisis the Fed played a crucial role in reducing volatility by stepping in as a buyer for certain high quality credit. While actual purchases have been relatively small, the capacity for the central bank to buy more remains large. According to JP Morgan and the Federal Reserve, the secondary market purchasing facility has spent only $12.8 billion of the $250 billion authorized and the primary market purchasing facility has been left untapped ($500 billion available), a crucial confidence booster to investors moving forward.
Pivoting to equity markets, we believe that the so-called break from “fundamentals and valuations” may not be as outlandish as some suggest. To look at equity valuation through current PE multiples is to subscribe to an incomplete picture of what is driving the markets. Taken alone these multiples paint a scene of investor greed and exuberance, but these multiples do not occur in a vacuum. Financial valuation is a relative science and to get a complete picture one must value equities relative to current market factors. Currently, earnings expectations for 2021 have stabilized with the S&P 500 trading at roughly a 20x multiple of consensus 2021 earnings of $165 a share according to a recent report from U.S. Bank. With interest rates at historic lows and expected to be there for several years into the future, valuations may be considered elevated though one would be hard-pressed to make an argument they are extreme, especially considering the fundamentals pushing multiples higher.
Near-historic low interest rates, non-problematic inflation, and negative short- to intermediate-term real yields all support these higher multiples, and that is just on the comparison side of analysis. Considering the digital adoption and mainstreaming of technology driving revenue and free cash flow of companies far above the levels experienced in the dot-com era, these multiples appear even more modest. Then, when analyzing these multiples through the relative lens of the Equity Risk Premium which is currently near highs of the past 50 years, these equities become downright attractive relative to other yield-bearing instruments. This is all a long-winded way of saying that while there will certainly be bumps along the way, we expect the trends driving the market to continue and therefore the market rally to push well into 2021.
Analysts and economists have described current market movements akin to the phenomena of the “Asset Pump”. This occurs when a market environment of low inflation, low interest rates, and excess liquidity combines with animal spirits. While asset-based discounted cash-flow models (DCF) and other traditional measures have indicated that historically this has lead to inflated valuations and asset bubbles, there is nothing traditional about current market drivers. The focus on free cash flow and liquidity or access to liquidity has dominated the mind of the investor since market turmoil began in late February and until we see changes in upcoming stimulus, the consumer, or vaccine development, we project this focus to continue steering the market into 2021.
Thank you for your continued trust in Partnervest.
Partnervest Advisory Services, Chief Investment Officer
AdvisorShares STAR Global Buy-Wrtie ETF (VEGA) Co-Portfolio Manager