DialoguesFidelity : Diversifier par la vente d’options d’achat et les stratégies d’options

[00:03:02] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. Sustained volatility is great for certain strategies, particularly when call options are an option. Income strategies are all the rage at the moment but Fidelity has been deploying such a strategy that first made its mark back in the 1970s. If investors desire the trifecta of a smoother ride through volatility, earning an income, all while remaining keenly exposed to growth in equity markets, this may be a moment for an extra shot of caffeine as we dive into derivative strategies today. Whether you seek to hedge market risk or gain income on the vol this is probably the discussion for you. Joining us today is portfolio manager of Fidelity Equity Premium Yield ETF and of Fidelity SmartHedge U.S. Equity Fund, Eric Granat. Eric, welcome, great to see you. How are you doing?

[00:03:56] Eric Granat: I'm well, Pamela, thanks for having me today.

[00:03:57] Pamela Ritchie: Delighted to have you join us here today. We'll invite everyone to send questions in for Eric over the next 30 minutes or so as we dive into this strategy that you brought to us a little while ago now. We'll kind of catch up with you. I wonder if you can kind of remind us how you use call options in the fund that you manage.

[00:04:18] Eric Granat: Sure, it's a great question. As you pointed out, we launched Equity Premium yield in September of 2024. This coming quarter we'll celebrate our one-year anniversary. It's an interesting strategy because it really has two core building blocks. We have an equity portfolio that's actively managed that is closely benchmarked to the S&P 500 index. We deploy a listed S&Ps 500 index option, a call option, selling strategy on top of that equity portfolio. That call option selling strategy really seeks to provide two things. First and foremost, we're targeting a 6 to 8% annual dividend yield primarily generated from the sale of call options. It's also important to note that the short call positions will reduce overall portfolio volatility by approximately 15% a year.

[00:05:15] Pamela Ritchie: That's really interesting. It is kind of a simple strategy. I'm curious how, well, everyone's curious how funds have done through the course of this very volatile last several months, how has it done, actually? It's done what it's meant to do?

[00:05:29] Eric Granat: Yeah, yeah, exactly. In your opening remarks I think you said something that's so important to investors or managers that deploy short options, whether you're selling calls as we are in this fund or selling puts, anytime you can sell options in a period where implied volatility is elevated we know that we can generate enhanced or high levels of option premium. Q2 and year-to-date we have had no shortage of implied volatility and uncertainty in U.S. equity markets, and that has certainly benefited the funds. Again, relative to our expectations of a 6% to 8% annual dividend year-to-date and since inception we are trending on the higher end of that expectation. Very pleased with that performance, also pleased with the total return performance of the portfolio relative to the long-only index, the S&P 5.

[00:06:27] Pamela Ritchie: Within the S&P 500 there are lots of companies that actually do provide dividends, does some of that income come into what you ultimately provide? You said a lot of it's self-generated from the call options themselves, but is it a mix?

[00:06:42] Eric Granat: Yeah, for sure, it's definitely a mix. We do own equities in the portfolio that pay dividends. This is a quantitative equity portfolio, we don't filter or screen based solely on dividends. I think that that's a benefit to the strategy. If you look at the top five holdings of the S&P 500 right now it's, of course, Nvidia, Microsoft, Amazon, Apple, Meta, those are also the top five holdings in our portfolio. We don't have to weight or overweight traditional sectors that pay a higher dividend, whether that's consumer staples or energy or maybe financials. I think that that's one important distinction and benefit to the approach of using option premiums for dividend payments.

[00:07:30] I think another interesting aspect that we should hit on is the fact that, you know, thinking about it this isn't a hard fact but going back 20 or 25 years I don't remember a period where we had an S&P 500 dividend payout in the 1.2% range. That's about where we are currently. The baseline dividend on U.S. large-caps is extraordinarily low and I think that's a supporting theme or attribute of the market currently which makes such strategies like call selling strategies so appealing.

[00:08:07] Pamela Ritchie: Within the world of what you do, there are others that do this, I think we mentioned that kind of the original strategy of taking a look at this, it actually goes back to the 1970s. What other pure strategies are out there, and, I guess, how is this different, what you're offering? You have quite a lot of exposure to stocks going up, and they are going up so that's a good thing.

[00:08:31] Eric Granat: Yeah, it's a great question. I've been directly involved with portfolio management or developing strategies in this space since 2004, an awful long time. There's just been a tremendous, and I would say somewhat consistent growth in this space. It's important to highlight over the last six to eight years assets and the number of funds in the covered call selling space has just exploded. We see that in the U.S., we also see it in Canada. There's an awful lot of ways that you can deploy this type of strategy. We take the approach that I think the big decision point for most managers is to say, okay, we're always trying to strike a balance between equity upside appreciation and dividend payment. There's an almost perfect relationship between the two. The higher the dividend payout that we want to provide from the fund, the less equity appreciation potential we're going to have for long term equity investors that are seeking capital appreciation. We tried to strike that balance. Again, we're targeting 6 to 8% yield. That's mostly coming from the options.

[00:09:42] I think that the investors or the audience on this call will find that we tend to be right in the middle, if you will, relative to our peers. We have peers that are deploying leverage or maybe using a more volatile subset of assets or call options that are going to produce option premiums that might range above 10%, and then we're going to have peers that will also target a lower percentage range. We chose 6 to 8% because over 20 or 30 years of backtesting analysis, and certainly a lot of personal experience, we think that that's a range that we can maintain across a wide variety of market cycles, whether we're in a very volatile period which we've just sort of passed through and might persist in for some amount of time, or if we get back to a period where investor confidence is very, very high and implied volatilities is low.

[00:10:33] Pamela Ritchie: Let me pick up on that. Do you think that perhaps we're in for a little more vol? I mean, it seems like it's been quite a first half of the year, although things haven't really settled down. I might ask you again but let's just get that question in there, why now?

[00:10:55] Eric Granat: It's really hard to predict the future. I think it's fair to say that we have a higher likelihood, at least in my opinion, of more exogenous shocks coming from the United States in the coming months. While that's not something we look forward to it will support a higher level of implied volatilities in the market. Said differently, I think that there's going to be a persistently higher level of investor discomfort with the markets. Again, personal opinion, I think it's a little bit harder to predict the future right now. That's okay, right? Uncertainty is part and parcel with what we do here. Despite all the uncertainty that we experienced in the second quarter S&P had a fabulous and very resilient return profile generating 515 bips in CAD for the quarter, so a very, very strong quarter, all against a very unsettling and unpredictable backdrop. That unpredictable backdrop, of course, provide us with elevated option premiums which benefited the account. Impossible to predict, Pamela, but I expect more of the same, at least for the next 12 to 18 months.

[00:12:11] Pamela Ritchie: One of the features of dividend funds or that type of investing is, obviously, the income but also they tend to be stable companies that when the market flips and flops they don't move as much. They are less exposed to the downside, if you will. This is similar?

[00:12:30] Eric Granat: This is similar in a way. You're right to point out that a traditional equity investment fund is going to favour and have a larger weighting or holding in consumer staples, energy, financials, maybe some utilities. We don't do that in this fund, right? We have an S&P 500 portfolio. We hold approximately 160 names in the portfolio with very, very tight sector constraints, industry constraints. We want to really replicate the risk and return attributes of the S&P 500. We think that that's beneficial, certainly when it comes to capital appreciation. Again, in a very strong equity market backdrop our decision to go with a straight S&P 5 allocation has certainly been beneficial. You're right to point out, however, that an equity dividend portfolio, that portfolio is going to generate higher dividends, of course. There's also going to be a slightly lower volatility profile to the holdings in a more traditional equity income strategy. I would say to offset that, or to counterbalance that, the short call options in our portfolio will, again, reduce our volatility by about 15%. To round out the comment, I think that we're driving at the same thing, a little bit less volatile experience with an attractive div payout where both strategies are achieving the same thing but with different mechanisms.

[00:14:02] Pamela Ritchie: You mentioned 160 names. Within the S&P 500 there's 160 stocks that are owned, that you've selected, presumably, for reasons. I just thought I'd ask you also about the sector decisions that you've made. They're not necessarily the traditional consumer staples, utilities and so on. Just take us to the 160 names rather than all 500, I assume you have a reason.

[00:14:28] Eric Granat: Of course. It's a little bit bittersweet, frankly, from a portfolio management side of things. Constructing a strategy, a covered call type of strategy, it would be very simple, particularly in an ETF format, to just go and buy a passive ETF that provides us with S&P 500 equity beta. It would be a one line item, of course, it wouldn't require a lot of trading. That's an approach that many of our peers take. We, of course, being Fidelity, we think we can do a better job than that. Although we are seeking to replicate the S&P 5 in risk and performance we always want to outperform a little bit. Buying a passive replication ETF guarantees we'll never have any alpha out of our equity allocation.

[00:15:12] Our team believes that we can generate alpha. As you look through the subset of the set of names in the S&P 500, it might be 502 names currently, there's going to be a couple hundred in there that you don't want to own, or aren't the best of the best. Our quantitative equity team I think is excellent at using a very popular factor, traditional factor approaches and also some non-traditional factor approaches to find the very best names in the category to create an equity allocation that has fewer than 500 names, we're currently running about 160, and yet provide all of the risk and performance attributes of the S&P 500 with the opportunity for some alpha opportunity as well.

[00:15:57] Pamela Ritchie: That's really interesting. Is this something in terms of a strategy, in this case sort of overlaid on the S&P 500 as the so-called universe, could you do this on other universes? We're going into outer space here a little bit but I'm talking about even a fund but also looking at other parts of the world where you look at another index.

[00:16:21] Eric Granat: I would say that's one of the most interesting and dynamic aspects of my job as a derivatives manager here at Fidelity. In many ways I'm beta agnostic. Whether we're working with, I guess specific to the option strategy, as long as we're talking about an equity portfolio that has an index or perhaps an ETF with a very strong options liquidity characteristics, open interest and trading volume, we can go ahead and adjust the attributes of that portfolio to either take that equity portfolio and turn it into a high dividend or a high yielding allocation or we could also deploy a put type of strategy to provide investors with the equity exposure they want but with a lower volatility profile with less exposure to potentially damaging drawdown. That's the fun thing.

[00:17:14] In many ways I like to think of options overlay strategies is one of the fastest ways our organization, or any investment organization for that matter, and expand the breadth, the scale and scope of their equity portfolio offering. We're always working, evaluating other equity markets, other equity indices domestically and also globally, keeping tabs on liquidity, open interest, all those types of attributes, and exploring future products. We have quite a few in the works. It comes down to a balancing act between what is popular, what the consumer is interested in and, certainly, what the capabilities of the market are.

[00:17:55] Pamela Ritchie: We should watch this space in that scenario. Maybe this is a moment to ask a little bit about the SmartHedge, which we've spoken about before. You've talked about it's really just sort of the other side. This is taking a look at making sure investors have an option to hedge certain types of market volatility and risk.

[00:18:18] Eric Granat: Thanks for bringing that up. SmartHedge is a product that we launched in January of 2023. It is also an S&P 500 tracking equity allocation, so we have a similar story on the equity side. However, we have a very different story in terms of the options that we're trading and the objective of the option strategy. At a very high level we're deploying a very actively managed long put strategy. You purchase puts to buy, I'll call it an insurance policy, if you will, on your equity allocation. It would be unfair, I think, to use the term protection. There's no perfect hedge but we deploy the SmartHedge strategy in our allocation to long puts to reduce the depth and duration of damaging market drawdowns for long term equity investors.

[00:19:11] Your question is really apropos. We just went through, certainly, the most volatile quarter since we launched SmartHedge in 2023. Just thinking about the worst of Q2 or Q1, Q2, the peak-to-trough drawdown from February 19th, in my mind, to about April 8th, this is 18 1/2, 18 3/4% for the S&P 500. SmartHedge was down roughly half of that, a little bit less than half of it. SmartHedge was down roughly 10% for that same period. I think for risk sensitive investors that really fear the worst equity market environment, so if vol goes up rapidly and goes to a very high level where there's a tremendous amount of uncertainty, these long put strategies can provide a sense of comfort and keep investors confident holding onto their equity so that they enjoy long term capital appreciation.

[00:20:13] Pamela Ritchie: That's massive to any strategy to have people want to stay in in the midst of really rocky markets sometimes. Again, have you seen that, stuck with it because they're not losing as much, essentially?

[00:20:33] Eric Granat: I don't always get as much feedback from the investors and who's in the actual strategies but I can tell you that one thing that was really interesting about the drawdown from Q1 [indecipherable] Q2 was certainly the resiliency and the strength in the S&P 500 after April 8th or 9th. We started out April 9th with the market rallying almost 10%, at least in U.S. dollar terms, had a very strong month of May, a very strong month of June. When you think about that in context to the investors who may have sold when things really got volatile in March and early April, you feel the pain of those market timing decisions and just how challenging it can be. For the people that sold in early April at the lows and missed out on this incredible rebound where we're now at close to all-time highs in the S&P 500, I think that underscores the value of having an allocation of your portfolio into some sort of strategy that is containing volatility.

[00:21:40] Pamela, it's important to note we compete against other hedged equity strategies. There's certainly some really big players in the space. We compete against min vol, we compete against the 60/40 allocation. I think hedged equities are somewhat interesting relative to those two groups because when you think of a 60/40 allocation we're not subject to the, I would say the dynamic correlation attributes of equity to bond relationships over history, which I think very more than many people realize. When you compare it to a min vol strategy, a strategy which I think very highly of, of course, min vol makes significant bets on low volatility sectors and certainly market cap. We're not constrained in that way. We are outright buying pure volatility, we're buying hedges and owning the equities that we really, really desire.

[00:22:37] Pamela Ritchie: Just coming back to something that you mentioned at the front, the exposure to capital appreciation of stocks which, again, there's some very big ones in the news that have been talking about earnings and everything else recently, you would not have wanted to miss that capital appreciation. Again, just to the degree to which you allow that exposure to happen within this fund, as well as the income piece of it, just sort of speak to that a bit.

[00:23:08] Eric Granat: The way we constructed the fund I think really reflects the fact that we are equity investors at heart. It feels great to see the equity markets go higher. The tremendous return in the S&P 500 index felt great in Q2. We want to celebrate that. We want to own the equities, we don't want to make bets in our equity portfolio that will position us to underperform the S&P 500. To that point, our equity portfolio performed in lockstep with the underlying benchmark. I think it's also important to point out that we generally trade our options or hold short call positions in our portfolio where we reflect an upside bias. It feels pretty terrible when the S&P is up a tremendous amount at 20 or 25% a year and you've really truncated the vast majority of that performance through a call selling strategy that doesn't provide enough breathing room for the equities. We're trading calls every single week in the equity portfolio, in FEPY, the Fidelity Equity Premium Yield. We are selling calls that are always between 2 and up to 4% out of the money. By frequently resetting our call options at least once a week, and setting them to a level where they're going to enjoy at least 2 to 4% of equity market appreciation, again, I think it positions us to really celebrate these environments where the equities move rapidly to the upside. It's great for the investor overall.

[00:24:39] Pamela Ritchie: Can you tell us a little bit about the underlying equities themselves? How often do you rebalance them, how does that look? You would then proceed to use call options on top of any new equities that come in or end those that go out and so on, how does it work?

[00:24:56] Eric Granat: It's a great question. The equity portfolios, also rebalanced on a weekly cadence. That's, of course, barring any major inflows or outflows. We're going to rebalance the equity portfolio at least on a weekly cadence. I think it's important to note, specific to your question, that we want to keep the sources of our alpha in the portfolio, if you will, as separate and distinct as possible. While we have an equity portfolio that owns 160 of the individual stocks that we like in the S&P 500 I am trading options at the index level. We do that for a couple of reasons. Obviously, we save a whole bunch on commissions. We like the settlement attributes of the options. Most importantly, it allows us ... at the time if we have a market that's appreciated 5% and we have a call option that sells in the money I have the ability to notify the equity team, or the other equity portfolio managers on the portfolio, to say, here's the amount of cash we need to raise to settle the liability on the short call. The equity portfolio's managers have the discretion to pick which equities or how they generate the cash. If we were deploying call options on a single stock level we would be forcing the sale of equities in the portfolio that we might not want to sell. We work specifically in cash settlement terms, not in physically settled terms with single stocks. Operationally it's simplistic but it also gives us the flexibility to decide which equities we're going to sell or buy and why.

[00:26:32] Pamela Ritchie: That is completely fascinating. Is there a future where this strategy would be deployed on top of actual funds that Fidelity offers, or is more likely to do other indices around the world or something?

[00:26:49] Eric Granat: That's a great question. We certainly have an appetite to deploy this across a wide variety of equity allocations. I would say that my initial preference would be that we like to work with options at an index level for some of the reasons that we just previously discussed. Again, I think options are a very attractive way to expand the scale and scope of an equity platform. If there are strategies on the Fidelity platform where we wish to offer as an elevated income offering or perhaps a lower risk offering we certainly have this capability. That's how we think of this team. We're solutions providers. We use options, future, swaps, in this case mostly options, to create highly customized, somewhat bespoke solutions to suit a specific need.

[00:27:42] Pamela Ritchie: That's fascinating. Let's go back to the market itself, what some of these equities that are in this portfolio are up against, where they're going from here and, again, just sort of your thoughts on a slightly more macro picture of why this fund might fit for people at this moment. I wanted to sort of end it off on why now and where it fits.

[00:28:07] Eric Granat: I think speaking specifically to the equity premium yield strategy, I think given the growth attributes of large-cap stocks in the U.S. there's a desire for investors to have that exposure in their broader allocation. I think whether it's demographics, whether it's changing investment appetites, there's a growing opportunity to provide products which offer an elevated level of income. I think that given our forecast, our concern, somewhat our concern but also our forecast for a period of prolonged elevated volatility in the market, we get excited, that's an opportunity for us. Let's monetize that volatility and let's enhance investor experiences through a phase that might be a little bit tough to predict, or a little bit of elevated uncertainty. Let's turn that potential challenge into an opportunity.

[00:29:05] Pamela Ritchie: The optimism is contagious. Thank you so much for joining us here, Eric, and taking us through the strategy, where it's going and maybe we'll look for other iterations at some point and catch up. Have a great summer.

[00:29:18] Eric Granat: Thank you, Pamela, you too. Thanks for your time.

[00:29:20] Pamela Ritchie: That's Eric Granat joining us from Boston today. Great to have a catch-up on some of those strategies. Here's a look at what is coming up on Fidelity Connects. Tomorrow, Wednesday, we're going to be focusing on high yield bonds. This is with portfolio manager Peter Khan. He's going to be reflecting on bond markets, we'll go deep into the credit spread story, where these belong, where they're rated, and where he sees opportunity, ultimately, through the rest of this year.

[00:29:46] On Thursday, Kyle Weaver and Becky Baker, portfolio managers of Fidelity U.S. Growth Opportunities Class. They'll be joining us for an update on where they're finding compelling U.S. equity investments, again, through the second half. Thursday's show is going to be presented with live French audio interpretation, just so you know.

[00:30:04] On Friday of this week, on the heels of the big banks kicking off earnings season in the U.S., we look at the banking and financial sectors, as well as consumer health in North America in reaction to interest rates, global investment trends. It'll be Lee Sotos, who's portfolio manager and senior analyst, as well as Thomas Goldthorpe, equity research analyst, joining us. That's the lookout for the rest of this week. Thanks for joining us here today. I'm Pamela Ritchie.