Exploring the Future of ETFs and Autocallables with Matt Kaufman

[00:00:14] Doug Heikkinen: Can we start by having you tell us a little about yourself, your journey to Calamos and what being global head of ETFs means there?

[00:00:23] Matt Kaufman: Sure. I'll try to keep it short. I started in my career about 23 years ago or so. I started at PowerShares in the early days. We were just getting off the ground in the ETF space. The ETF itself was only about, say, seven or eight years old then. The funny story that we would tell, or that we like to tell, is that we got our exemptive relief from a larger asset manager in Chicago, and they basically made the comment that we don't think there's any room for growth in ETFs anymore.

The S&P 500 is taken, the NASDAQ's taken, the Dow's taken. And so we don't know what else to do. We felt differently. We thought there was a lot more room for growth in ETFs, and turns out that was the correct assumption. We built the smart beta ETF space there At, PowerShares, taking a lot of institutional type strategies and bringing them into the ETF world.

Back then the challenging educational component was teaching advisors and teaching investors that you didn't just have to market cap weight everything in et TF land, you could do it differently. And that sounds a bit archaic now, but that was where we were back then.

After PowerShare sold to Invesco, I went to an actuarial consulting firm. It sounds a little bit coming outta right field saying it, and it felt that way doing it back then. But the head of that group said, I have all the actuaries I need. I want to build funds. Out of our risk management strategies and we had just built over a hundred ETFs.

I said, we know how to do that. We went over and, a couple of us, and started building funds out of the hedging strategies that we were doing on the balance sheets of life insurance companies. Learned an insane amount about futures and hedging and options and learned what makes a balance sheet work for life insurance companies.

You think back to the timeframe that was 2010, interest rates were near zero, if not at zero, and the value proposition that insurance companies and a lot of banks could provide was also very low. You couldn't get good guarantees from variable annuities. You couldn't get good participation rates on your fixed annuities or your capital protected notes.

So it moved that whole insurance segment and the banking world as well into a risk sharing model where rather than principle protection, you'd get something less. You would get a buffer on the market, a partial principle protection level. So I was the president of our broker dealer at the time.

And what we've found is that you could deliver that way more efficiently with options than you could with a balance sheet. We did not need a balance sheet from an insurer or a bank to replicate a partial principle protection level on a market like the S&P 500. We developed some intellectual property that did just that.

We developed some buffer strategies. This was about 2016. We delivered that into the market a few different ways. We gave it to some insurance companies for their variable annuity books. Gave it into a UIT provider and then gave it to an ETF client to build the first defined outcome ETFs in the market.

So we built that space in 2017. That's been growing tremendously. I started at Calamos, about two and a half years ago. Calamos has been doing these types of payoff profiles for 40 years. They're the largest convertible manager in the country, second largest globally. A convertible looks very similar to a payoff profile of an option strategy largely because it incorporates options.

You get the upside of a company's stock, you're tied to the upside. You've got a call option on that, and then on the downside you're tied to the bond. And being able to talk to John Calamos Senior, and seeing the parallels between the things that we were building in the option space, and the things that he had been doing for the last 45 years and said, we want to build into the future.

We're doing private credit. We've got hedge equity strategies. We wanna build an ETF line. So it was a, a great time and opportunity to come over and basically take what Calamus has been doing for 30 or 40 years and use new tools. Use the tools that advisors were looking for, build it with ETFs, use options.

We just built an income, ETF on auto calls, which uses swaps. We can talk about that. But that is, the last 23 years. And, it's, it's been a fun ride.

[00:04:47] Doug Heikkinen: It sounds like it, the derivative income category has grown significantly. Can you help us understand this trend and where Autocallables fit in?

[00:04:57] Matt Kaufman: Yeah, that is a massive space. I was fortunate to be part of the group that built the first covered call ETF. The first buy right ETF was a PowerShares ETF. I believe it was about 2008 we launched that. Not many people bought it. I don't think they quite knew what it was back then. Fast forward 10 years and you see almost 300 billion in assets tied to options based strategies in the ETF world. Largely, as a result of the SEC rule.

You have 6c-11 and then you had a derivatives rule that followed, which allowed for the efficient delivery of options based strategies in an active framework. It's just, you say the word active, which an ETF land just means it does not track an index. It's not a passive index tracking product.

But a lot of active ETFs in the market today, a lot of them are options based. In the derivative income world, you have covered call strategies in the ETF side. It's about $115 billion space. It's very large. You can think of the JEPIs, JEPQs, different types of covered call strategies that will sell some upside, collect a coupon or collect some income for that.

And then you hope the market doesn't go down so far, to eliminate the coupon that you've just taken on or erode that coupon. So in the structured note world, those are bank products. Derivative income also happens to dominate, but it does so by way of a product called the Autocallable.

So the Autocallable, you can think of that like a bond, but whose par value, whose principle and coupons, are tied to the equity markets instead of credit duration or some other traditional bond factors. So that Autocallable space has grown tremendously. It also is about a hundred billion dollars a year market.

There's about a hundred billion dollars a year in issuance in the structured note space, all tied to Autocallables. There's a thirst for income and there's a thirst for differentiated sources of income. A lot of investors have seen interest rates go from zero to 5%, come back down a little bit.

There's a lot of uncertainty in the interest rate environment, even who's actually controlling those levers. I think right now we're curious where Trump is going relative to Powell and if that's even his decision. But nonetheless, there is some interest rate uncertainty, and that's causing a lot of investors to start to look for income that's differentiated from those traditional bond risks.

[00:07:35] Doug Heikkinen: What are the key risks advisors should understand about Autocallables?

[00:07:39] Matt Kaufman: Yeah, that's a great question. you are taking on deep equity tail risk in exchange for a coupon. So those are the risks. That is the risk you're taking on. So if you think of a covered call strategy which a lot of advisors might be familiar with. You sell off your upside, you collect a coupon, hoping the market doesn't erode that coupon as it falls. Here, you can think of it like a bond.

So again, you're tied to the equity markets, not falling too far. There's a couple of terms that might be new to some of the listeners here. A barrier, would be a coupon barrier and a maturity barrier. So instead of terms like buffer or floor, a barrier simply is a down and in put level.

So if you had a barrier option on the S&P 500 set at minus 20, that would mean that if the S&P 500 fell by 20 or more, then you knock in and you lose that amount. If the S&P 500 falls by less than 20, then you don't, and you keep all of your money. So in that instance, if the S&P was down 15%, you would still get your par value back.

You'd get your coupon. So the barrier is an important term relative to auto calls. That's how you would size and understand your risk. So if you think of maybe a 40% barrier that's tied to a coupon, let's say your coupon's 12%. You will always get that coupon every month, so long as the reference index is not down below that barrier level when you observe that coupon payment and then if it's a three year note, same is true at maturity. If that level is not below the barrier at maturity, you get all of your principle back at maturity. The odds are, as the name implies, you'll get called away early because there's an auto call feature inside these products.

That is an operational, I would say, risk. But we've heard from advisors, also an operational nightmare. A lot of times they'll enter into Autocallable notes. They'll buy a few different ones from different banks. They'll get a decent coupon for that. A few months later, they'll get called away.

If the index appreciates beyond the call level, they'll get called away. They get their money back, they get that final coupon, and they have to go shopping again. And it's a very, arduous process. But what we just did with the Autocallable Income ETF, CAIE, is we put all of that into a single ETF that's just very automated.

So it's really hitting the easy button for advisors was, using their words, not mine, but I'll steal that marketing term.

[00:10:17] Doug Heikkinen: Yeah, so Autocallables have traditionally been limited to institutional investors. Your Calamos Autocallable Income ETF changes all that. So can you talk more about it?

[00:10:28] Matt Kaufman: Yeah, that's right. So what we've done is we've collaborated with two other high quality groups. JP Morgan as a swap counterparty, and then MerQube, which is a leading custom index provider, who does a lot of indexes for structured products, for a lot of ETFs. We've used them on the ETF side as well.

I've known the CEO there for quite a long time. And so we collaborated together to solve this Autocallable problem for advisors in the market. Our goal was to deliver the Autocallable space in a way that was transparent, efficient. It just was a laddered exposure, diversified out the maturity risk, diversified out the coupon risk.

So what we worked on and what MerQube built was a laddered index that replicates the performance of a weekly issuance of an auto call. Each one of those auto calls, there's 52 or more in there, have a five year term, a one year non-call period, a 40% coupon barrier, a 40% principal maturity barrier, and they're all tied to a US large cap Vol Advantage index that MerQube has also issued.

So each of those auto calls is tied to the performance of that underlying index which has been optimized for Autocallables. There's about $3 billion worth of notes currently in the market tied to that MerQube Vol Advantage Index, largely issued by JP Morgan. We have collaborated to build all of that inside of an ETF wrapper. So you're not just getting exposure to one auto call.

You have 52 or more of them entered weekly, laddered exposure. So instead of betting everything on a single entry point or a single maturity point, you're diversifying across time, and everything is happening inside that index. And we just trade that index on swap with JP Morgan. So it's a remarkably efficient experience.

When you do this inside of a swap, or inside an index that we trade on swap, it's remarkably tax efficient as well. So about 3%. I'll tell you the coupon, I left that the good part out. So right now the average weighted coupon of that laddered index is about 14.5%. So that's an annualized coupon. And from a tax perspective, in our ETF we hold a lot of collateral, a lot of treasuries, so we'll have to distribute about 3% of that as ordinary income.

The other 11% or so, our goal is to distribute that as return of capital. So there's good rock and there's bad rock. Bad rock would be giving you your money back to you just returning your own capital to you. Good rock would just be treated as return of capital. So what that means is your coupons are largely going to be tax deferred.

Then it's going to reduce your cost basis. So if you buy in at 25, collect some income off of that, maybe your cost basis goes down to 15. Then when you go to sell, you'll just pay long-term capital gains on that difference between the 15 and whatever you sell at. Maybe you sell at 25. The other interesting thing we're seeing advisors do is using this to generate nearly tax free income for their older clients, older investors.

And then the clients are going to bequest those shares to their heirs. And when those heirs get the shares of CAIE, they'll get a step up in basis and have no cost or no taxability on those shares. So what the advisor's done is created largely tax-free income for their older clients, and then when they bequest those shares, there's no taxable event.

[00:14:14] Doug Heikkinen: That's great. How else does CAIE fit into a portfolio and what are the applications that you see?

[00:14:21] Matt Kaufman: Yeah, so because these notes mark to market with an underlying equity index, you'll see volatility in the NAV stream that looks a lot like the S&P 500, maybe a little bit higher beta, slightly higher volatility.

So that's important to note that your experience in the fund is going to look a lot like an equity experience, but you're going to have coupon, you're gonna have a high, stable coupon for that. The way that a lot of folks are thinking about this inside the portfolio is, there again, there's a big desire for income.

So you might swap out some of your traditional equity exposure and now turn that into an income payment. If you think we're in a range bound market over the next several years, or maybe you don't think the market's gonna go up more than 14%, this would be a way to lock in that coupon.

And as long as you don't hit a severe drawdown in the market, those coupons are going to be there. So people are trading equity exposure for this type of income. Some might think of it like a high yield bond replacement. Maybe you get 7%-8% yield from a high yield bond, and you have default risk in a severe sustained drawdown in the market.

Whereas here, you're trading that default risk, or just equity market tail risk. So a differentiated risk source. Some people are pulling from that bucket as well.

[00:15:37] Doug Heikkinen: Yeah. Last one for you. How might CAIE adapt in response to shifting interest rates and or market volatility in the next 18 to 24 months?

It's crazy out there.

[00:15:48] Matt Kaufman: We're gonna get a little bit in the weeds here, so hopefully everybody stays with us. But we have, the reason that I personally love the MerQube US Vol Advantage Index is it's been optimized and built specifically for auto calls. So if you think about your covered call strategies, going back to those ETFs, you sell a call and the coupon or the premium you collect is largely based off of volatility in the market. So it's variable. One month you might get 1%, one month you might get, half a percent. It all depends on volatility. So in our ETF, the reference index has a stable volatility. And so that allows us to stabilize that measure inside of our options pricing. So every week when a new note is going into the ladder, it largely has a similar coupon as all of the other notes because it's working off of the same parameters. So you're tied to interest rates a little bit. What we've seen is about 8%-10% over a one to five year corporate bond rate.

So that's where you get to about a 14% coupon right now. If rates go to zero, your coupon might go down a little bit, but you're not going to go down as much. Maybe you're in the seven to eight range. Just making an assumption. But what I love about this particular product is, it does not rely, it does not rely on volatility movements like other Autocallable do, or like other derivative income strategies do.

[00:17:18] Doug Heikkinen: Matt, this was all very well explained. Thank you so much for joining us and best of luck.

[00:17:24] Matt Kaufman: Oh, appreciate it. Thank you so much.

[00:17:26] Doug Heikkinen: To learn more about CAIE and all that Calamos has to offer, please visit Calamos.com.

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