Description

Situation Overview:

Due to the macroeconomic backdrop over the last several years, I have been expanding my hedge toolbox and updating my portfolio management approach to implement volatility-dampening mechanisms into my portfolio construction that do not expose me to additional downside while capturing only incremental upside. But why dampen volatility in your portfolio now with the VIX near all-time lows? Obviously, less volatility likely lowers your daily profit and loss fluctuations (albeit there is a multi-factor discussion that could be had, but this is not the place for it), and also helps support the emotional output required to manage capital. However, it also allows you to play offense in different parts of your portfolio when there are idiosyncratic dislocations across single-name securities or dislocations in market-related securities and even across asset classes.

The consensus ways to lower volatility across a portfolio usually involve utilizing short exposure by reducing portfolio length, buying downside hedges, or even entertaining a discussion of gross exposure flex management and of course an allocation to private equity and private credit. Rather than turning this into a whitepaper about portfolio construction or risk management approaches, which happens to be one of my favorite subjects… let’s keep this simple…

Enter “Volatility Laundering”:

Volatility laundering has developed a negative connotation recently, but I think it is now just commonplace inside institutional and retail portfolios. Most of the aim is towards private equity and private credit, with many even yelling from the mountaintops that there is a bubble developing…and once the PE and credit books must mark their books to market, volatility will increase and create a contagion effect across asset classes. Perhaps...

Trade Idea:

Embed a new layer of “volatility laundering” into your portfolio by increasing net long exposure (net length). Yes, you read that correctly. Seek out different ways to embed vol laundering that you can risk-manage as well as trade around via adequate liquidity into your portfolio and engrain it into your portfolio construction. The net result is positive by having the ability to pay for hedges/increase convexity, thereby increasing your rate of return and potentially lowering drawdowns during episodic periods of higher volatility (insert any reason for the volatility you want…).

Buy position in ticker MTBA and hedge with a short position (pick your ratio based on your view of interest rates or acceptable net carry) in 10-year Treasuries or consider using an ETF such as ticker IEF, the iShares 7-10 year Treasury bond ETF. Currently the duration of MTBA is ~5 years, so there is some basis risk so I don't like running this block delta neutral until shares/flows improve.

Why not just pitch downside protection using VIX instruments and S&P products like SPY?

First off, all these downside structure pitches tend to receive a fair amount of pushback always on timing re why now?!?! You are a market timer boomer/doomer…buying protection used to be considered sound portfolio and risk management, but now you are effectively a doomer. Second, I think buying protection (vs outright shorting single-name stocks or buying credit protection) is a systematic portfolio construction process but also involves tools for identifying opportunistic periods to hedge via pattern recognition. Lastly, I prefer to at the very least evaluate ways to seek out positive carry to better ‘pay for’ downside convex structures before bombing downside protection; This opportunity has the potential to dampen volatility across asset classes within the portfolio, and is a nice addition to cash management.

What is MTBA:

MTBA is a newly listed ETF and currently has ~7mn shares. This ETF invests in mortgage-backed securities (MBS). The fund will primarily invest in newly issued Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA), and Federal Home Loan Mortgage (FHLMC) instruments. The effective duration of this portfolio is 3-10 years (currently 5 years and 4yrs as of 12/31/23). I am not going to discuss the expense structure or other aspects of the ETF that you can read in the ETF prospectus, but rather focus on the return stream and volatility laundering. Owning agency MBS is effectively a volatility laundering security whereby you own a 7-10 year US Treasury while executing a covered call strategy re collecting additional yield. Agency MBS carry “no” credit risk and less call away risk of the underlying via prepayment risk. MTBA was created to effectively purchase newly issued higher coupon MBS and is monetizing an expensive call against the underlying to produce a relatively safe 6% return, today. Why can’t I just buy MBS directly or another ETF? The answer is you can, but the other products investors have access to via index in the MBS space own securities that have locked in lower returns/lower coupons and are therefore inferior for a variety of reasons. Currently, 10-year US Treasuries yield ~4.25%. MTBA is currently purchasing agency MBS yielding 6% (the highest ETF exposure currently is Fannie Mae 6% coupon bonds) and has a spread of nearly ~2%. I expect this carry to stay in this range or even improve as capital is deployed by the fund at attractive coupons.

A Brief Discussion of Position Sizing Considerations:

This is really a portfolio management and risk management decision, but I tend to have a ‘hedge budget’ on a rolling 4-5 quarter period, so more about science than art re what is my portfolio risk of loss under different scenarios. Just to be clear, this is not a bet the market will go lower. Hedges are for hedging and it is better to do so when the cost is low, and hedging activity is low and you don’t have to hedge. A hedge is a hedge, re just in case the market goes lower and/or volatility increases. Per above, I spend 1.25-1.5% for downside protection on a 4-5 quarter rolling period. I use downside protection structures such as down 5/15 put spreads, down 10/20 put spreads, and sometimes utilize outright down 5-10% puts depending on the volatility backdrop and which structure is the most forgiving. I prefer this approach over the use of tail hedging strategies. Other structures that also help pay for the cost of protection include buy-writes and selling calls against puts via collar structure, which I am a fan of opportunistically. Historically I use rolling 4-5 month options for indexes and don’t hedge using single names unless there is a risk that is mispriced and I want to dampen the downside, but don’t want to exit the position in exchange for cash due to tax implications (with cash yielding 4-5%, this has become more attractive vs the last several years). A full MTBA position, (subject to a few constraints including liquidity in the interim) delta-adjusted is far from $ neutral and the net carry is a couple %. Current net hedge book outlay specifically for downside protection via index options e.g. SPY June/August down 5/15 put spreads as well as some expressions on the 10-year. Additional trades would be including downside structures in single name banking/brokerage common stocks/options or options in a broader ETF like the KRE but that is more of an alpha bet vs expanded approach to portfolio construction.

Summary:

In summary, long MTBA as another way to embed volatility laundering into your portfolio and pay for portfolio convexity (upside and downside) and works under many macro scenarios. Happy to discuss macro scenarios that a structure contemplated in this brief write up, leads to outsized and difficult to manage losses. Outright long you collect 6%. Long MTBA and use collected premium to protect your portfolio or define specific downside risks in your portfolio(s). This will allow you to play more offense during market dislocations. Long MTBA and short ratio 10-year treasury and collect via carry trade. 

Stats:

NAV:50.70 (trades at small premium)

Distribution Frequency: monthly

Net expense: 0.15%

Avg daily volume: ~100k (should increase as flows increase)

No K-1 (helpful as this can be a burden / non-starter)

Catalyst

Volatility laundering: carry, collect, dampen volatility, hedge