In this episode, Jeff Malec sits down with Rick Silva, the co-founder of Metaurus Advisors, a boutique asset manager. Rick walks us through Metaurus Advisors’ innovative approach to understanding and trading the equity risk premium using dividend futures markets.
Rick Silva provides insights into the firm’s background in derivative markets and their goal of bringing fixed income securitization techniques to the equity space. He explains the concept of parallel tranche securitization applied to the S&P 500 using dividend futures, which offers visibility into how the market prices equity cash flows and the equity risk premium.
Rick and Jeff discuss the strategies Metaurus has developed to harvest risk premiums in the front-end of the dividend curve across different markets, as well as the introduction of new futures contracts based on sequential tranche securitization of a 100-stock index. The episode also addresses the challenges and opportunities in the dividend futures market, including differences across regions, and for a little fun, we fall down a political rabbit hole – SEND IT!
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Check out the complete Transcript from this week’s podcast below:
Unlocking the Equity Risk Premium with Dividend Futures
Rick Silva 00:06
I can actually mathematically take the S&P 500 now and break it down over time using these instruments. So as opposed to buying a whole market, which is essentially one dividend strip in perpetuity, I can overweight just like you trade the yield curve. So if you have a methodology, not just to price it, but to trade it and isolate it, then I think it opens it up.
Jeff Malec 00:31
Welcome to the Derivative by RCM Alternatives, send it.
Rick Silva 00:36
Hi. I’m Rick Silva of Metaurus advisors, and we believe there’s a different way, or alternative way to think about and look at the equity risk premium using the dividend futures market. And I’m here to talk about that on the derivative you Rick, good afternoon. Thanks so much for having me. I’m Rick Silva. I’m with a firm called Metaurus advisors. We are a boutique asset manager. The Metaurus advisors is, it’s, it’s an interesting place. So we’re small. There’s about 10 of us and the principals at Metaurus we actually first met in very early 1990s at Merrill Lynch, and we were part of the team that built Merrill Lynch’s equity derivative and structured note business. And then we left and we went and we did that again at Morgan Stanley, and then we did it again at wa COVID, and then we did it again at Wells Fargo. So we’ve been involved in derivative markets, you know, for the better part of the past 35 years. And so the idea behind the Taurus is we wanted to kind of continue to look at the same spaces and and solve the same problems for for investors, basically help, helping them understand, you know, what markets they can look at in order to to identify and affect interesting trade offs of risk and return, so they can, you know, build better portfolios for the most part. So the first thing we did at natars, which you know, kind of leads us to where we are today, is we looked at a lot of the technologies that existed in fixed income, specifically in this area of securitization, where, you know, the marketplace is very comfortable taking an asset like the bond, like a bond, and breaking it up into its component cash flows. And they’re also very comfortable taking a portfolio of bonds and carving up different risk tranches off the back of that, and it’s brought a lot of liquidity, and I think it’s, it’s added a lot of value to the fixed income markets. It’s not been without risk, right? I mean, remember 2008 you know, some of the CDO squared and things like that. But a lot of those technologies have never really migrated over to the equity markets. And so one of the things that we spend time at matarsh Thinking about, and this goes back, you know, over our years together at all these different firms, is, you know, what are some interesting ways that we can take some of those technologies and bring them into the equity markets to help make those markets more liquid, more efficient, to carve up new and different ways to allow investors to express risk and return views. And so the first one we did, why do
Jeff Malec 03:26
you call them technologies? What’s that? Are there structures or technologies? Well, they’re think of them, one in the same. Well, I’ll give you an
Rick Silva 03:33
example. I’ll give you an example. So, so the first thing we did at the Taurus was, you’re probably familiar with fixed income. You can take a bond and I can strip coupons from the zero coupon return of principal. That’s basically a parallel tranche securitization, where I take an asset and I create two different interests in it. So investor A owns the coupons, investor B owns everything else that’s left over the return of principal. So that concept, we thought was really fascinating, and could it be applied to equities? And practitioners have thought about doing that of stripping, you know, an equity asset, apart stripping out the dividend cash flows, or the cash flows over time and and leaving the residual. And so that was the first thing we did. We did a parallel tranche, securitization on the S, p5, 100, and we use the dividend futures market. That’s the marketplace that had evolved from an over the counter market to an exchange trader market that allowed us to do that. But before we get into that market at a concept level, we took the S P, we created two, effectively ownership interests, or economic interests in it. One ETF was a 10 year dividend strip. The price that that traded at reflected the present value of the markets. You know, the implied dividend expectations over time it paid out the actual dividends. So you bought implied dividends, you received actual dividends, and you bought implied dividends at the risk free discount. So what that was, was actually a way to begin to kind of carve up the equity risk premium. The other piece was the market without the first 10 years of dividends. So the strict market. And what’s interesting, when you do this, you know number one, you’re taking the S, p5, 100, and you’re breaking it into different risk profiles now, right? Because the two together, if I bought one of the dividend strip and one of the market and I held them, it’s kind of boring, but I will have just recreated the S, p5, 100. And so break it apart. You don’t just break apart the cash model growth profile, but you’re breaking apart the risk and return profile. So, so that’s where we started. Um, we,
Jeff Malec 05:42
we, isn’t it weird? Real quick, yeah, weird to think about the right if you read, anyone who’s pitching you on owning stocks is like you want to you are getting the future earnings growth. I guess that’s reflected in the price my my thought was going to like if you’re just owning the dividend growth, that’s sort of equivalent to the earnings growth or No,
Rick Silva 06:02
no, it 100% it’s another dynamic. Because you’re, you’re the earnings growth is implicit, and then you have how much of that earnings are going to be, those earnings are going to be these via dividend. But, like, the the whole thing, if, when you, when you price a bond, okay? It’s nothing more than it’s a discount cash flow analysis. Okay? So 10 year 4% coupon bond is just a promise to pay $140 over the next 10 years. Yeah, value the bond. Just the market. What the market’s debating is, what’s the right discount rate to use to discount each of those cash flows, right?
Jeff Malec 06:34
Well, ignoring credit risk and everything and
Rick Silva 06:38
everything, and so if you, if you move out on the credit curve. That’s right, it’s not just the risk free rate. You have a credit spread, and that credit spread is the credit risk premium, and it’s identifiable, and it exists over time, right? There’s one year credit spread, a two year credit spread, a three year credit spread, and you’ve had instruments now that have developed where you can trade that credit spread in isolation. I can trade it in the investment grade bucket. I can go trade at CDs, things of that nature. But for fixed income investors, the idea of time and duration is fundamental to the portfolio construction process. It never was in equities, and part of the reason for that is, you know, companies don’t. Companies borrow debt at every conceivable maturity, but they don’t, you know, JP Morgan doesn’t have a five year class of shares and a 10 year class of shares. They just have JP Morgan stock. Yeah. So even though, just like a bond, the stock is a financial asset, it’s a claim on the future earnings of the company, and dividends are how companies return those earnings to to investors. The price of the stock at any moment in time reflects the risk discount to present value of all of its future expected cash flows. And so what you’re talking about, which is the implied, you know, growth, you know that that is really, fundamentally, that’s the equity risk premium. And because, you know, there’s a ton of academic work, and we’ve had the very good fortune of working with, you know, one of the leading practitioners, a gentleman named Professor Dan bins burger, who’s down at Wharton. But you know, he tells this story where he says, when he teaches finance, he’s been the first two weeks doing discount cash flow analysis and how to price bonds and stuff. He said, then, you know, we turn the page and we move to equities, and we do the dividend, dividend discount model where, you know, I basically have a dividend, I have a growth expectation, and then I price it like a perpetual annuity. And he says, I can always tell the smart students, because they’ll raise their hands and say, Wait a second. We just spent two weeks understanding for a series of known cash flows that there’s a different discount rate, different credit spread at every point that you used a discount, and now you’re talking about a variable cash flow asset, and there’s only one growth rate and one discount rate. So he wanted to dig into that, and that’s, that’s the basic scores work, but, um, but that’s
Jeff Malec 08:51
the crux of the whole problem, right? The bond has a fixed term, that’s right. So, so is it just, hey, this was too complex in the beginning to figure out for most people, so we came up with a different model, right? Fixed Term versus infinite term.
Rick Silva 09:05
So it does. But I mean, I guess you have to ask the question, is there a spot in the equity markets where you actually price terminal equity cash flows? And the answer is, there is, and it’s in the equity derivative marketplace. And if you think about all the options and futures and structured notes and things like that that are traded out there a they’re all linked to the price return of whatever the underlying equity is, and they all have defined terms. And so if you’re pricing a call option on Microsoft, right, you know what the payout is. But if I, if you’re buying the call option for me,
Jeff Malec 09:37
guys, you’re you’re putting time frames on that infinite time frame, via futures, via options, via Got it, got it. Exactly
Rick Silva 09:45
right, exactly right. If you were to buy the call option on Microsoft, and I’m selling it to you, right, yeah, implicitly my hedge is to go along some amount. Microsoft stock, so I’m going to receive that dividend. So I need to think now, where am I going to price that dividend? And so that happens in structured notes, options, futures, the implied dividend is embedded in all of that. And so that market became very, very, very large. It was the over the counter dividend spot market. And then after the financial crisis, it moved to a clear format. They started listing these, essentially these dividend swaps on the exchange.
Jeff Malec 10:26
And before that, groups would be market making, selling options or whatever, needing that dividend exposure. So they would go to the swap market and be like, Hey, can you give me a swap on Microsoft dividend growing more than x exactly,
Rick Silva 10:39
or go the other way, where, you know, if I was given a structured note three years and I had to figure out, Okay, how much credit am I going to give for the three years of s, p, dividends, I would price it. Then I’d say, I don’t want that, right? I’m an I’m an options. I want to get paid my premium in cash, and I don’t want to get paid in future dividends. So then I would turn around and find a place where I could offload it. And so I would try and sell that, that risk to insurance companies, pensions, hedge funds, you know, institutional investors who get paid to take that. I mean, the market
Jeff Malec 11:09
makers do both. So they’re owning that Microsoft stock and hedging the dividend out or neither, right? It depends on who they are. But, yeah, yeah,
Rick Silva 11:16
no, that’s, that’s absolutely correct. That the so, that market which, which started, you know, grew up off the back of the the equity derivative marketplace. It became very, very large, but it was actually what it allowed, was visibility into how the market at a consensus level, prices, equity cash flows, how does the market think about the term structure of equity returns. And the was talking about Professor bins burger, he went in and he looked at this historically, using over the counter, you know, he had some proprietary data that he was able to get OTC swap, dividend swap books, you know, the marks on that. And then in 2009 the first eurox listed dividend strips on Euro stocks. Japan did it in 2012 and the CMD listed in 2015 on the S, p5, 100. But you now have this whole marketplace of dividend strips. And so, you know, if you go back and you think, okay, a bond is nothing more than a claim on a future series of cash flows, the fixed rate, fixed term annuity. I know easily how to price that. And as you pointed out, the complexity in equities was at its variable rate, right? Dividends aren’t guaranteed. They’re linked to earnings. You could have earnings can go down, and dividends won’t change. You could have earnings rally huge, and dividends might not change, and they’re perpetual. And so how do you price it? But until
Jeff Malec 12:42
they’re not, that’s the other piece, they’re perpetual, until they say we’re suspending dividends, or whatever, yeah,
Rick Silva 12:47
suspend their dividends. And then what that does, though, is that is really reflection of an extension and duration in the marketplace, right? Because now I can take the S, p5, 100, and I can price it just like a bond. I can take that dividend strip market, which, by the way, they’re already risk discounted prices, right? Like if we were doing, you know, it wasn’t sophisticated, but 2530 years ago, if we were trading something on the S, p5, 100 in the expected yield was 275, I’d have to figure out, Where am I willing to take that risk? Where do I think I can sell it? What kind of discount that’s the same thing as a credit spread, right? Discount JP, Morgan versus Jet Blue, where I want to discount S, P versus a single name,
Jeff Malec 13:28
right? So to summarize, you have now you have two fixed calculations on the bonds, easy. This is the present value of that future cast stream with a in with a defined endpoint. Equities, I’ve got this strip of dividends, which I’ll put a defined end point on it. But even though it’s not defined, those are two easy calculations. Now, on the bond side, the trick is credit risk. On the equity side, the trick is dividend risk, for lack of a better term, or what do you call that? Of like, are they going to grow, suspend decline? What is the dividend rate? That’s right,
Rick Silva 13:59
we call that the dividend risk premium. But really what it is is it is the equity risk premium, premium. And so you could take that dividend strip, that 10 years of dividends on the S P, if I and they’re already risk discounted, right? Because that’s the market traded prices. That’s if you asked an analyst like, historically, dividends over the past 75 years in the S P, they grow at about 6% call it right and up years at 7% there’s been six negative years, the average negative year, but for 2009 was negative 1.6 right? So it’s a fairly stable asset, but if you looked at where that growth was trading in the market today or recently, it’s pretty close to zero. So that’s the discount. So they’re not forecasting a lot of growth and dividends in the marketplace, because that’s where they’re willing to buy and sell that risk,
Jeff Malec 14:48
right? Is it sort of like they’re just punting on that? Like, I don’t know what that is, so I’m just going to price it at zero growth and see what happens.
Rick Silva 14:54
Well, I analogize it to credit spreads, right? I mean, are they punting when? JP Morgan, credit spread. 40? Should it be 40 or 50 or 60? I don’t know. Right? If the risk environment changes, credit spreads wide and if treasuries go from zero rates to 6% high yield, spreads aren’t going to be 200 basis points. They’re going to be 500 basis points. So it’s a risk market exactly in the same way that that is. But if you took the first 10 years of dividends and you discounted them using the Treasury rate, right, just the present value of what they were, and you came up with that number. You added them all up, and you compare that to the value of the S p5 100. That dividend strip, the value of it represents the first 11 years or 10 years of the S p5 100. So if $100 of s, p, if the present value of the first 10 years dividends was 12, then 12% of the total market value is attributable to dividends to cash flows in the next 10 years. The difference is the residual that’s attributable to earnings and dividends in years 11 and beyond. So that was, I did, an exit that that was taking the market and breaking it up over time. So, so what’s interesting? There’s, there’s a bunch of stuff that that comes off of this. No, we could talk a little bit about,
Jeff Malec 16:11
yeah, and this is all, I guess I was, this is all known math. This is out there. This isn’t anything proprietary. This is just, this is how dividends work, and how it’s all priced in the swaps and now in the futures.
Rick Silva 16:23
Yes, that’s right, that’s right. But what’s new? It is no. I mean, it’s visible, right? And the markets move around. And if you looked at like, the growth rate in the US right now is slightly positive, if you went and you looked at the UK or Europe, it’s significantly negative, like the dividend strip looks like, you know, it falls off a cliff Japan is pretty normally sloped. So, you know, these different markets trade and discount those equity cash flows based upon the perceived risk in those markets. One of the senior guys in in the group said, hey, you know, Rick, go tell figure out what the equity risk premium was for the past three years. And so I was like, Okay, great. And I was like, no idea what the hell the equity risk premium is. I looked at somebody else in the group and a smarter guy than me, I said, What’s, what’s an equity risk premium? They said, it’s easy to figure out. Let’s go figure out what the total return of the S P was each year for the past three years, and then compare that to what the yield was on a one year Treasury in each of those years, and then that excess represents the risk premium. Right? The risk premium is just how much excess return do I require, or do I expect to earn in order to take risk beyond the riskless asset? Right? A credit spread is a pure, isolated risk premium. It is the credit risk premium. JP Morgan is trading at 50 basis points over treasuries. It’s 50 basis point credit risk premium. So I did that exercise, and I got an attaboy, and, you know, things were good, and went all with my life. And then, you know, 30 years later, we’re looking at these dividend markets, and we’re reading the academic research. And if you think about it, if, if you’re talking about the credit risk premium, if I asked you, where is the five year credit risk premium for JP Morgan? Would you take a five year JP Morgan bond and compare it to a three month t bill? No, yeah, different duration assets, and compare the five year JP to the five year treasury. I compare the one year JP to the one year treasury. And so you actually have a term structure of credit spreads, right? People used to think of the equity risk premium as one number, but it’s just above cash, just above cash, or three month t bills, or one year. The reality is now, if you want to try and understand what the one year risk premium is I have a one year dividend strip, and I can compare that to a one year Treasury, and I can see how did that perform. And if the market is the present value of all of its future cash flows, then the total equity risk premium is the aggregation of all the individual risk premiums. So when you go and you start thinking about what is the equity risk premium, it forces the question, what is the fixed income counterfactual that you’re trying to compare it to? Right or,
Jeff Malec 19:07
or what’s your time frame like? Great, there’s no just one number, what is it over x? What is it over y? Exactly?
Rick Silva 19:12
And if you’re trying to do the whole market, the exercise is, what’s the duration of the market? Because that’s the Treasury that I need to compare it to. Right now, we don’t have 50 year duration bonds in the US, but if you went back, so what Van Bens burger and his partner and Ralph question was at Chicago, what they did is they went into the equity marketplace and this dividend strips market to understand historically, how has the market discounted equity cash flow is, what is that risk environment? What has it been? And so they created, just like you would in fixed income, a one year constant maturity, a two year, three year or four year, all the way up the curve, right? So they did a one year constant maturity dividend strip, a two year, three year. And they did this across a ton of markets, right? Japan, Europe, UK, US. And they looked at the risk return profile of it, and then when you aggregate it all up, it forces you to look at the market risk premium. You have to compare it to a very, very long duration fixed income asset. So in the US, you would compare it maybe to a 20 year bond or a 30 Yeah, it would be about as close as you could get. But what they understood, or what kind of emerged from the research, was the the distribution of that risk premium was not what they were expecting. In fact, shorter duration equity cash flows offered higher risk premiums, generally speaking, than longer duration equity principles. So there were more heavily discounted versus expectations and versus outcomes. So now you have what used to be thought of, like, if you if you talk about the bond guy or a credit guy, right, they talk over it’s about the continuum of time. Like, you know, where is the best place to be on the yield curve? Where does the place to trade credits. You cannot do that in equities. And so this is the, you know, off the back of that original i, o, p, O. This is some of the stuff that has been opened up now. And so these are, these are some of the markets that that we’ve been looking at. It’s
Jeff Malec 21:15
interesting. Like, the word risk premium gets thrown off around an awful lot, right? So a lot of people just be like, there’s a risk premium in equities because they can go down, yep, right? They’re just saying, that’s why it goes up. And use the word risk premium without any stats. As you said, it just could be the simple, it’s over cash, but you’re saying no, no, it needs to be considered in each time frame, like a bond, like a strip of two years, five years, 10. Um, interesting. All right, there’s gonna, I’m gonna noodle on that for a sec. So back up real quick. We went. We shot through your bio there quick so you were at rattle those off again.
Rick Silva 22:00
I started at Merrill, and then I did a short stint on the buy side. Then I spent a bunch of years at Morgan Stanley, then went over to Wat COVID and Wells Fargo. That was my sell side. Substantial background before reconnecting with
Jeff Malec 22:14
but that was sort of the same adventure we were just talking through, of like, learning the bond structure term structure, and then moving into the equity term structure,
Rick Silva 22:21
yeah, working across asset classes, working across geographies, you know, understanding basically derivatives, derivative risk. You know, financial pricing. How do you price financial assets? What are the techniques used to estimate future cash flows, forward cash flows? You know, how do they trade? How does the risk market look at them? And
Jeff Malec 22:40
what would you say? Sure, I’ve had plenty of hedge fund guys on here who would be like, discounted cash flow model is BS, right? Or if, like, trying to even price these securities, is BS, like it. They either go up or down. There be animal spirits, systematic, intraday trading, whatever. The thing is, they don’t care about what the discounted cash flow. Is it like, How do you square that with, like, actually trying to get a price?
Rick Silva 23:06
Well, the price is the price. And if you’re, if you’re talking about bonds, it’s there, right? You can see it. You know exactly the different components that you can trade. And so, can it go up? Can it go down? Yes. Why do credit spreads widen? I’m not smart enough to figure that out. Only in hindsight can we figure that out, right? Yeah. Why do equity markets move around with lots of different factors factor into it? But what I believe, and what I think is true, is the the price of the of an equity at any moment in time reflects, right? A market consensus. I’m not saying whether it’s rich or cheap, it can go up, it can go down, but it’s a market consensus of the risk discounted present value of all the future cash flows, that’s it. And now that we have this dividend market, what I can say is I can trade it so it doesn’t matter what people think. And I still can’t explain why it goes up and why it goes down, but I can actually mathematically take the S, p5, 100 now and break it down over time using these instruments. So as opposed to buying a whole market, which is essentially one dividend strip in perpetuity, I can overweight just like you trade the yield curve right, just like you’d build a fixed income portfolio. Doesn’t mean you’re going to get it right. Doesn’t mean you know you were targeting a three duration. It should have been a seven, because you know that what the environment turned out to be, but I think these cash flow, I mean, that’s all a financial asset is. So if you have a methodology, not just to price it, but to trade it and isolate it, then I think it opens it up. Yeah,
Jeff Malec 24:38
I think their argument, my fictitious bogeyman here would be like that. It doesn’t matter what you think the price is, which is essentially what you’re saying too. The price is the price. But you can get into a lot of trouble with your model saying, No, this is the correct price, and it’s right. Infinitely higher, infinitely lower, and you’re trying to sell into that, or buy into that. And. Get into a lot of trouble. That’s, I guess, my point of,
Rick Silva 25:02
yeah, no, and that’s fair. And I would analogize it like this, like I would say, you know, if you were talking about volatility markets, right, I don’t know where the heck the fix is, they’d say it’s like a 21 or whatever. That’s the price of the VIX. That’s the cost of insurance. Is that the right price? I don’t know, but I know that’s the price. And so with the dividend strips, my comments on discount cash flow analysis are less about is the risk premium accurate or inaccurate? But I can now identify it, and if I have a basis for reasonable you know forward expectations, whether that’s through someone popped on my screen, whether that’s through forecasting models, bottoms up analysis, and I can see where these things are trading on the screen. Like, the same way people buy, you want to buy higher. You want to buy investment grade. I don’t know. Where do you think you get the better risk return opportunity, right? Yeah. So it’s a subjective assessment of the risk, and as close to an objective assessment of the return as it possibly can be. And in equities, you never really had a very objective assessment of return. And now I’m saying you do more and more with this marketplace
Jeff Malec 26:15
and and that allows you to do things like buy the sell the front month, buy the back months? Yeah, we, I’ll use air quotes for the listeners, but basically, right, if you, if you can separate those into time frames with the dividend strips, Yeah, same
Rick Silva 26:31
way you would trade the you know, build a credit portfolio, right? Like a duration neutral credit portfolio over time. We do that. We do a couple things we have. So we have a public ETF where we that we do in partnership with a wonderful company called pacer financial. They’re the cash cows guys. If you’ve ever come across those guys, they are. They’re awesome. You’ll see them Sean O’Hara, you’ll see them on the CNBC and, you know, box business and stuff like that. But with Pacer, what we do is we essentially isolate a three year dividend strip from the S p5 100, and then we overallocate to it and under allocate to the S p5 100. So if you go back to the i div X, did the 10 year dividend strip in the market without the 10 years, if you put them together, you just recreated the S p5 100, but if you put them back together in different ratios, you’ve now changed the cash flow growth profile the S P modified its risk return profile, so that ETF, we actually pay out the actual dividends as they’re earned. And so that makes quarterly distributions at a rate of four times the actual S P dividend yield. And it has a market date of about 90, and it has a volatility profile between 80 and 85% of the s, p, so it’s a very growthy, very risk, efficient growth and income strategy. That’s one thing we do, right? And that’s mostly geared for investors who are looking for market data, but who want to tailor their their, you know, kind of growth and income and risk return profile. What’s
Jeff Malec 27:58
the symbol? Are you allowed to say, what’s that? What’s the symbol, Qd,
Rick Silva 28:03
pl, quadruple for four times the and we, we rolled it out on NASDAQ. You’re
Jeff Malec 28:10
forexing the dividends. Or no, you’re only, what’d you say? 120 to 4x in the dividends. So you’re owning 4x the dividend strips. And how much of the S P about
Rick Silva 28:22
85% 85 to 90% you’re all in beta. So we’re doing is we’re taking the net annuity profile and we’re we’re pulling it forward for you a little bit so you can harvest more of the earnings and dividends in the early years. You’ll get less of it in the later years, right? So the portfolio for 100 bucks of quadruple, I literally hold $85 in the s, p5, 100, and that gets me 85% of the dividend. And then for 15 bucks, that’s how much it cost me to go into this strip market and fully pay for another 315% exposure to earnings and dividends in years one, two and three, right, put together again four times in years one, two and 380, 5% in years for and beyond. So as opposed to, you know, tilting sectors or selling calls and things of that nature, we’re just time waiting the s, p, we’re shortening the duration of the market got so that’s one thing we do. The we also have a strategy that you guys are familiar with, where, when van bins, burger and coition went in, and they started looking at, you know, the individual strip markets to say, how does the market systematically over time? Or do they systematically or persistently? How do they discount cash flow? Because it’s a big market, so whether they’re intending to or not, things will emerge from it. And what they found is that shorter term equity cash flows offered higher risk premiums than longer term equity cash flows, right? So if you think of the market as one risk premium, equity risk premium, you wanted to break it up over time, more of it would sit in the front end, and less of it would sit in the back end,
Jeff Malec 29:58
because. Simply because of future uncertainty.
Rick Silva 30:04
Honestly, there’s a bunch of reasons. There’s some market structure reasons because most of the derivative flow is in the short end. So there are more natural sellers on the front than there are in the back. But it’s still a risk asset, so you still should have a risk premium. The other reasons are, there’s a left there’s a left tail, right. If I’m long one year dividend and it gets cut, right, I’m gonna realize the loss. You don’t have time to make it up. I don’t have there’s no recovery. So there’s a left tail there. You’re getting compensated for the left tail. But, but they look, they looked at this, and I also has a much lower cap and data so,
Jeff Malec 30:40
and and I’m thinking of that reverse, so front end has a higher risk premium, meaning it’s cheap, more cheaply priced. Yes, right? In bond terms, it’s has a higher you, yes, yeah.
Rick Silva 30:50
Then, then the back end. That’s right, that’s right, okay,
Jeff Malec 30:53
and that, because of that factor, the back end has longer to make up for any short term pickup Exactly, exactly
Rick Silva 30:59
right. Markets, individuals, you get into the behavior side of it, where investors are much more risk averse in the short run than they are in the long run. Right? Everybody’s worried that next year, this year, the market’s going to be down. If I said 10 years from now, what do you think? I don’t know. We’ll be fine in 10 years. I’m not Yeah, you know, if you’re borrowing money, you know, say, I need to borrow money for one year, and then you say, Yeah, let’s make it two years. You’re gonna get a very different interest rate. If I say, Yeah, borrow money for interest rate if I said, borrow money for 29 years. You know, let’s make it 30, whatever. But the dynamic they uncovered, and by the way, it’s not what they were expecting. Higher risk premiums in the short end, lower cap and datas, which means, if you take the S, p5, 100 again, which is all the dividend strips, and you allocate to the piece of it that you know, with a higher risk premium and a lower cap and data, and you under allocate to here it actually has a higher sharp ratio. And so we run a strategy where we harvest the risk premium in the front end of the dividend curves in US, Europe, UK and Japan, and there’s a lot of stuff we incorporate that informs what maturities we’re picking, how we’re allocating across the geographies and things of that nature. But we go along the front end and we hedge out the beta any residual data there by going short the back end, and the hedge ratio is really 20 to 30, somewhere in that range, generally speaking. And so we’ve created a beta neutral access to an equity risk premium, just like you would in a credit portfolio, right? You’re trading bank loans or you’re trading CDs, but and that strategies can all done very, very well. But back to vans burger when, when they discovered this, that’s not what they were expecting, right? They thought, well, the longer the term, the more uncertainty, the higher the risk premium. And among the things that kind of help them, can help convince them that this is actually a very viable conclusion, and it actually is probably persistent, or really two things, number one, that profile hell across markets. So it’s not like it was only the US or only or only Japan, so Right? It was consistent across equity markets. And the second thing is, they went back and they started thinking about and they’re like, wait a second, there’s lots of other assets that have this same profile, right? Housing, corporate credit volatility, and so it started to comport with the bigger picture of, you know, other assets and had similar behavior and so, and then, sure enough, like we’ve been looking at it, the date of the research goes back, you know, 2530 years, we’ve been active in it since 2018 and that’s when we launched either the next day. And then we’ve been very active in it, you know, post COVID.
Jeff Malec 33:52
So, and then you mentioned volatility in my brain, when you said harvested, right? I think of selling option premium. So does it have a bit of a negative skew, short gamma profile, right of like a COVID type, something bad in the front months, it’s gonna, it’s gonna hurt you.
Rick Silva 34:09
It does. It has, it has a left tail, for sure. It’s very safe, as measured by cap and beta. So like in 2022 you know. Okay, fine. Markets sell off because rates are going higher and there’s inflation fears didn’t impact anyone’s expectation on 2022 earnings and dividends. 2324 but what you saw in that scenario is people say, Well, geez, the recession, they come in. 2526 so the back end of the curve sold off if you go into 2020 what happened?
Jeff Malec 34:39
That was actually a good thing for you, right? There’s great thing for us. Yeah, right.
Rick Silva 34:43
So we’re the risk in the strategy. Is the systemic risk. It’s the COVID risk, right? Where all of a sudden, the
Jeff Malec 34:51
911 COVID some sharp and acute, exactly,
Rick Silva 34:56
something that causes a reset of short term expect. Rotations, yeah.
Jeff Malec 35:00
But would you say less than being outright short rent, less than that same trade in the VIX, if I’m short front month VIX, long back month? VIX, well
Rick Silva 35:09
yeah, VIX, I would imagine would have a lot more gearing in it. And we use, actually, that relationship in vix to help inform the sizing of the strategy. And when you start to see distortions in the credit markets and in the volatility markets, those historically have been precursors to forthcoming events. The market has been pretty good setting up ahead of things. And so we use that to inform you know, maybe we should dial down the strategy a little bit in terms of notional exposure or leverage. We also have a commodity trend following strategy, which is, this is a little bit different, but the other thing that we just launched, which it’s actually not launched yet, but we entered into a partnership with the Chicago Board Options Exchange to roll out a series of futures contracts based on some technology. So in the very beginning, we talked about I did the next step as a parallel tranche securitization over the idea is, what are things that the market is doing in fixed income that might make sense to kind of explore in the Application class? So iOS and POS are parallel tranche securitization. The next thing we wanted to tackle was sequential tranche securitization, which would be CDOs, Clos, things of that nature, where I take a pool of assets and I basically carve it up into performance tranches. And if you really think about what is a CDO, right? It’s it’s a series of better of and worse on outcomes and the senior when you capitalize a pool of assets, the senior lenders get the best performing bonds, right? Said differently, the equity tranche gets the worst performing bonds. The first default eats into the equity and as long as you don’t have enough bed performers to eat into the collateral that’s really sitting behind the senior tranche, then the senior tranche is fine. So we wanted to think about, how do we do that? Is
Jeff Malec 37:09
that after the fact in CDOs, and it’s or before the fact, like, do they pick out which they think you’re going to be the best? Or it’s by rule, after the fact, the worst go into this bucket the best.
Rick Silva 37:19
So, so in a CDO, you start off, you pick what the assets are that you’re going to benchmark to, but the outcome is ex post. So it’s after you get to the end, right? It’s only after you have a default that you have an outcome in strategy. So we applied that same approach to equities. So we have, we build an index without getting into all the technical stuff, it’s basically, it’s 100 stock index. Each stock is equally weighted. It’s the sector weightings are interesting. So the index itself actually has very, very, very highly correlated to the S, p5, 100. So it’s only 100 names. But if you were to just buy that index, it would look and feel a lot like the S p5 100. But we basically created an equal weight S P out of 100 names.
Jeff Malec 38:08
I think he could have just bought five names or seven names and looked awful lot like the S P, F
Rick Silva 38:13
for the past five years, for sure, for sure. So, so we have this, that’s the master index, and then we have off the back of that there are two sub indices. One index is called the lead index, and the other one is called the lag index. So if you think about it, the master two tranches. Two tranches, the best performers and the worst performers and and so the master index of total return index where all the corporate actions are captured at the constituent level, so not reinvested across the index. And it’s a horse race, and we run it for a quarter. And whatever the 50 best performing names are, I don’t know what they’re going to be until I get to the end of the quarter, those names will sit in the lead tranche. Everything else, the 50 worst names will sit in the lag tranche.
Jeff Malec 39:02
And so what is as an index? And then there’ll be futures on that index. Well, we’re going
Rick Silva 39:07
to list futures on the lead tranche and the lag tranche. So you go to any investment, you say, Okay, three months from now, would you rather on the best performers or the worst performers? Most people would just instinctively say, well, I’ll take the best performers. Okay. Question is, how much you willing to pay for that,
Jeff Malec 39:23
right, right? So if you if that price gets bit up and it’s no longer risk reward,
Rick Silva 39:29
well, you would expect that the lead tranche futures, the futures linked to the lead index, would trade at a premium to NAV. So on day one, the NAV of the index is 100 and the two tranches are 1550, I don’t know what names are in it, but each stock is worth $1 right as they move around over time, the NAV of each of the tranches has to equal the NAV of the index the futures contracts. If, if the lead tranche is trading at a 5% premium to NAV, then in an arbitrage free model, that means. The lag tranche has to be trading at a 5% discount, discount, because those two have to also add up to the to the index, right? So that’s realized dispersion. It’s realized return dispersion,
Jeff Malec 40:11
but not dispersion, as we talk about on this podcast, a lot of volatility, dispersion, of dividend dispersion. Or how do you define that? So I mean, or maybe they’re one in the same, because that dividend action causes the volatility to spring. Yeah, it’s kind of
Rick Silva 40:26
the next level down. So most of the correlation indices and things like that that look at, you know, implied vol between the index and the constituent stocks, those are all implied to implied but none of them have a Realized outcome. And we actually have a Realized outcome here. So you’ll have a return. There’s a beta in it or a delta in it. The pricing of those the futures contracts will have to capture the implied vol on the market and the implied correlation in the market, because it’s basically a better than a worst of option, if you want to think of it like that, right over time they’re going to converge. But what’s unique is it actually allows you to express a directional view as well.
Jeff Malec 41:10
They need to launch a tell them next time you meet with them. Right? All these RAs are selling these best of products, but like S P, Russell, NASDAQ, like you get the worst of or the best of on the upside, those would be interesting futures too, to allow them to hedge.
Rick Silva 41:24
Well, these futures will will be the natural other side of it, because the lead tranche, you know, will have an embedded correlation exposure, the lag tranche will have the opposite side correlation exposure. So you can use this to lay off some of that risk.
Jeff Malec 41:38
Now, how do you think about in all this that you’re doing with the dividends the NASDAQ companies that don’t pay dividends, yeah. How does that work? Into the math, if at all, or what, right? How do you price those? Go ahead, whatever your comments are in, though, that seems like a thorn in your sign,
Rick Silva 41:56
- Well, it’s, you know, it, it was the NASDAQ, it will remain to be seen, right? Because NASDAQ dividends are that’s kind of has a lot of call option features, like with S, P dividends, the you have upside surprises, but most often it’s a downside surprise, right, where companies or sectors get whacked, or, you know, financials cut their dividends, or you have that kind of stuff with NASDAQ, just to give you a metric. So last year, I forget what the index itself was, up the dividend growth. Last year in the NASDAQ outperformed the index itself. So really you had Google get all those guys to clear into Salesforce, meta, Google, right? And there’s only, I think it’s about, I think, like, maybe numbers may be off a little bit, but I think it’s about 80 plus percent of the S, p5, 100 names paid dividends with the NASDAQ. It’s closer to 50% so the play there is, really, which is
Jeff Malec 42:58
that up from like 10% 20 years ago, has it always been?
Rick Silva 43:01
No, it’s, I mean, I, I could cheat and pull up my graph, I have it, but yes,
Jeff Malec 43:06
it, yeah, off the top of your head. But it’s been steadily growing, steadily growing
Rick Silva 43:11
and and, you know, if you read the fundamental stuff out there, and, you know, you look at the environment, and there’s a lot of pressure for companies to start to return capital on this, as these tech companies get larger and larger, right? I mean, a lot of them are growing through M and A activity, their their revenue base, their sales are stabilizing. They have positive earnings, you know what? What are they?
Jeff Malec 43:31
You’re looking more like a S, P company. You need to start acting like it,
Rick Silva 43:34
pretty much, pretty much. So, so, yeah, so that’s NASDAQ, and we’re looking at potentially doing it on some other international indices, but that that could be a whole suite. We call it the dividend multiplier strategy. So with Pacer, we would do this in partnership with our good friends at PACER, we have a suite of ETs where, you know, investors can build their global portfolios, or advisors, RIAs, whomever, and you know, if they’re looking for growth in income, or if they want to, you know, dial down the risk a little bit, or change the income profile of their portfolio. You know, they’ll have the opportunity to use this suite of ETFs to do that across markets. Do
Jeff Malec 44:18
you listen to the podcast smart list with Jason Bateman and those guys. They’re always saying for my sister Tracy, but I say for my friend George. So explain for my friend George exactly how the dividend futures work. Like, what are they quoted at? They’re quoted as the growth percent or the dividend No.
Rick Silva 44:35
So they’re actually quoted in dividend index points. So so they list contracts, so they’re traded on the CMA. They they’re annual. They have quarterly maturities, but we deal with the annual with the quarterly maturity. Sometimes the company’s dividend moves from one quarter to the next year. Yeah, looped around, right? But typically, over period, it’s much more stable. So they list the current year in the next 10. So you always have 11 years of contracts. Mm. Hmm, they mature in December of their contract year, okay? And they’re quoted in in dollars, but it’s index points, and then there’s $1 multiplier that brings it to a certain notional exposure. But the way they work, they’re they’re linked to something called a dividend points index, and so for the S p5, 100, S P publishes the dividend points index. And the way that index works is it begins the year at zero. So for instance, the current year when the 2000 on the third Friday of 2024 December 3 Friday, December 24 the final value of that dividend points index determined the final cash settlement value of the futures contract that next Monday, the index resets to zero, and then every day for the next 12 months that a company, the S P, pays a dividend, S P takes the dollar value of it, and based upon the company’s waiting in the index, converts it to a number of index points, and it just talents it during the course of the year. And so when you get to the end of the year, that futures contract, and today it’s trading about 78 for the 2025 is trading at about 78 bucks, whatever the total dividends paid over from december 24 to December 25 will determine the final cash selling and price of that contract.
Jeff Malec 46:13
So it’s whatever, 78 divided by 6000 or whatever
Rick Silva 46:18
is the yield is the implied you got it but, but you’re buying the implied yield. Yeah, people don’t think about this, but if you look on the screen, you say, Okay, what’s, what’s the implied yield? Where are these things trading? It’s trading like one and a quarter, roughly, give or take, the actual dividend yield on the S, P has been coming on between 170 and 185
Jeff Malec 46:39
and they couldn’t quote it in, right? They had to make it difficult so normal people couldn’t understand it like could have quoted it in the percent yield. We paid extra for that. So it’s already 1.3% through, I guess, the first quarter. What is the yield? What is it? That’s
Rick Silva 46:55
the price that you have, that you pay for it. So what happens is, during the quarter, as that dividend points index accumulates when we get to the end of the quarter, I know exactly how many dividends have been earned on the S, p5, 100. So, so it’s
Jeff Malec 47:07
wait. It’s going to be 58. Is the how much has been received, and 20 is the
Rick Silva 47:13
20 to go so, so if we bought it for 80, and we get to the end of q1 and it’s at 20, that means $20 of risk has been taken out of the contract, and it’s been and basically your remaining risk for the next nine months is now 60. And what you’ll see is those that those contracts will start at like 75 right? And then as the dividend points come in and affirm where the actual growth rate is going to be, the contract will migrate up and they will converge that material. And that’s the dividend risk premium.
Jeff Malec 47:44
And so the 11 year out, one’s trading at like a 10th event is my quick math at like, 567, something like that. No,
Rick Silva 47:52
- So, I mean, I’ll pull it up on the screen so it’ll just
Jeff Malec 47:56
get 10 times more valuable over the Well, no,
Rick Silva 48:00
no, no, that’s the thing. The implied growth rate in those dividend futures contracts is like 1% per annum. So the so the 2000 it’s about 7785 right now, the 25 okay, the 2032 is at 8250 so what does that mean? Again, getting back to Yeah, that’s weird. It should be Yeah. What can I do with this information? If the S P goes to the moon and that curve doesn’t move, would you rather buy the S P and pay it essentially a massive multiple for earnings 1015, years out? Or would you rather buy exposure to earnings in years one to 10, you might get better value.
Jeff Malec 48:39
What did people so people use options to do this on individual names, right? Like, Nvidia comes to mind. Like, I don’t want to own it, so priced up, there’s animal spirits in there. Like, can I just own the return the dividend stream instead? I don’t know if they even pay dividends. Probably not. They don’t pay a dividend.
Rick Silva 48:56
It would be tough to isolate it, but if there was a company and you’d rather exposure, you could isolate and strip the dividend out. But what’s interesting is, you know, the US is a is a funny place sometimes. So you have the competing regulator, regulators, right? You have the SEC and the CFTC, who constantly trip over each other in the space of derivatives, right? Is that? Is that a commodity, or is that inequity? Who regulates it? So they can’t figure out who’s going to get be in charge of the single stock dividend futures. So the UX lists on so you can go into Europe right now, I think there are list I looked there were 29 us names where you could trade dividend strips. They list them for five years, typically. And in Europe they list them on sectors. So, you know, if you just want to take a view on the financial sector, maybe you want to sell it, because that’s like buying and put right
Jeff Malec 49:46
and talk through me globally what everyone’s main index looks like, s, p, versus so Euro stocks or whatever, versus Japan. Like, what are those dividends running at right now? Yeah,
Rick Silva 49:57
so it’s funny. So, um. Um, great question, by the way, in the US, as we said, it’s basically flat in the early years and then very modestly upward sloping. You know, you get about 1% one and a half percent growth per annum. Um, Japan looks a little bit like the US now. Japan isn’t as liquid. They only list five years, and you really get, you know, most liquidity sits in years one to three, but that’s normally sloped. And it’s actually just sold off today pretty significantly. But it’s positively sloped a little bit, right? So it looks normal. If you if you ask somebody to draw what you thought the curve would look like that, it would look like what they would draw. If you go into Europe, it is upside down. It is massively inverted. No, it’s inverted. It’s a W, oh, it’s inverted, not even a W. It’s just a downward check it’s like an upside down check mark in the UK looks exactly the same.
Jeff Malec 50:46
Wait, what’s the logic there? It’s all going to be invaded by Russia. There will be no dividends ever. I
Rick Silva 50:54
just, it’s just a risk market. I think they’re just looking and saying, you know, yeah, like, I don’t know what the prospects are going to be eight years out. And so if you want me to take the dividend risk eight years out, the regulatory environment, the geopolitical environment, all the stuff that’s going on there, I need to get compensated to take that risk. So you have, like, I’ll give you. So this is in Euro. So the Euro stocks, I don’t ignore that. Euro stocks is today. Well, it’s about 5200, 5300, the 2025 contract in Euro stocks is trained at 165 166 somewhere in there, the 2030 contracts train at 142
Jeff Malec 51:30
but they generally pay a higher dividend. In Europe,
Rick Silva 51:34
they have a higher payout ratio. In general, yes, yes. And the world is higher. So the relative value of the dividend versus the index is hotter over there.
Jeff Malec 51:42
And what are those payout ratios generally look like, S P versus Europe versus Japan.
Rick Silva 51:46
So historically, S P is like, you go all the way back it Yeah, 50% right now it’s like 25 to 30% so we’ve, we’ve had a huge period of earnings growth, and the dividend growth has stayed at 789, percent, but it hasn’t matched with earnings,
Jeff Malec 52:02
right? You’re but I’m saying just the actual dividend on the SP last year was, what, three and a half. I don’t know what
Rick Silva 52:08
the number, no, no, the actual in the s, p was about, like, 180 last year. 180 got
Jeff Malec 52:12
it versus Europe’s maybe, what double then, yeah,
Rick Silva 52:16
like, it’s over 222, and a half. Maybe Japan’s about, Japan’s over two. But the key is the payout ratio, right? It’s how much of the earnings are they returning in the form of dividends, and then the yield is a reflection of the valuation of the market relative to that payout ratio.
Jeff Malec 52:32
Is that partly, I guess there’s plenty of smart, well healed people around the world by the right, but partly, of anyone playing in this game is just playing in it out of the US versus globally, so you don’t get as much interest.
Rick Silva 52:45
No, no, no there. So in the what matters is doing, I think, is a little bit unique, because we’re looking at these markets to build portfolios and to create systematic, you know, strategies that you know, not purely hedging, or women? Yeah, I think in other markets there’s a lot of hedging. Here they look, you look, you could trade options on these things too. And like I know a lot of the big the Canadian pensions, the Scandi pensions, they’ll look at this opportunistically. And so when you get a COVID event, some COVID, what happens? The market sold off. The short term dividends didn’t really move because people like, oh, okay, you know. But then they sent people home from work, and then out in Europe, they started jawboning about, hey, banks should suspend dividends this year. And then you saw a complete collapse in the front end of the curve. In the US, the big sovereign funds came in and actually bought that. So they’ll wait for the less left tail, and they’ll they’ll come in and provide that liquidity.
Jeff Malec 53:44
On the flip side of that, I know some long ball funds that actually will sell them as a long ball play, finding it cheaper to hold than right, buying puts or holding the VIX or whatever they’re
Rick Silva 53:57
doing that is exactly right. There’s no lost premium. There’s a dividend risk premium that will erode over time. But you can simply look at, you know, how much option premium am I going to spend to buy out of the money puts or to get exposure to vix versus the dividend strips? So all these, all these things should have relationship to each other.
Jeff Malec 54:21
We’re gonna finish up. What intriguing rabbit hole Have you found yourself diving into lately? Personal or professional? Well, I’ll tell you my rabbit
Rick Silva 54:29
hole, but I don’t want to talk about it because I’ve been obsessed with this dilish stuff, like,
Jeff Malec 54:35
All right, let’s do it. Yeah. Did it, what? Yeah, and where you’re in Connecticut. I’m in Connecticut. So what’s the mood there? Like, everyone, what the heck is happening? What’s going on, or cheering it, or panning it, you
Rick Silva 54:50
know, Connecticut’s a weird place. You get it’s funny, because you get the outrage. Like, you know, well, what are they doing? This? We need to, you know, help the rest of the world. And we can’t be put. All this stuff, and then you actually point out the stuff that money is being spent on. They’re like, Yeah, well, that’s stupid. We shouldn’t do that. And so, you know the I mean, I give Trump credit because he finds the 8020 issue, and he puts himself on the 80% side of it, even though the 20% side would be very loud, and even the 80% side might not realize that they’re on the 80% side until they actually are forced to look at it. So I’ve been and I don’t know there’s, there’s this young woman who is a data scientist. She’s deaf and has some physical challenges, but she’s freaking brilliant, and must just hired her to the team, but she’s been doing a ton of just data mining. Now that a lot of this data is becoming public, and so there’s just so much. I mean, it’s so discouraging in so many ways. But, you know, it’s, it’s like, you know, whatever, just the gore of it. Yeah,
Jeff Malec 55:58
right. I feel like it was Miss. They could have promoted a little better, like, we’re going after the the pork projects, the bacon like, all that stuff. That is, to me, the fix is put it all. Every single line item has to be voted on. That’s the problem, right? They stuff all this stuff into one big bill. Half the people don’t probably even know what’s in it as they’re voting on it. Yeah, no, I agree. Half of Congress, I’m saying much less that Americans, yeah. So by the time it gets to us, we’re like, what? What are we doing? Yeah, but someone promoted that, someone wanted that in there for their own interest,
Rick Silva 56:31
their own interest in you know, remains to be seen how nefarious those interests are, but I’m sure more will be uncovered over time. But like, one of the most controversial political things over the years has been the line item, veto right, where you send a bill to the President’s desk and he can say, Okay, I’m gonna, I’m gonna sign this, but I’m gonna veto that. I’m gonna veto that. I’m gonna beat the so nobody they want to jam it all on the big bills for exactly the reason you pointed out.
Jeff Malec 56:56
Kind of back. What does that do to your what is this administration. Doge, right? There’s been some ups and downs. What’s that done to dividend markets that moved
Rick Silva 57:07
it’s moved them? Yeah, I think the market is trying to sit through. You know, as the equity market has sold off, you’ve seen the back end of the dividend curve sell off, right? Because, remember, all of them together equal the market. So if the market goes down, some of them have to go down. The front end has held up pretty well, but you’re starting to see some risk evident in you know, if you look at credit spreads, if you look at the time structure of vix and some things like that, are starting to indicate that that left tail risk is starting to kind of heighten a little bit. So you’re starting to see some of the front ends sell off a little bit. We haven’t seen anything material, but it definitely has us, you know, very focused on that.
Jeff Malec 57:51
My rabbit hole is my son is reading Great Gatsby for English class, and he was asking me about it, and I started to pick it up right back through it and getting into all the green light and looking up now these days, you don’t just have to think about it and talk with your right back. There’s YouTube clips and whole blog posts on what all this means. So I was diving down into all that symbolism. And was it really intended, or was it not?
Rick Silva 58:17
Yeah, which was the rabbit holes that the kids throw you down are awesome sometimes. Oh yeah,
This transcript was compiled automatically via Otter.AI and as such may include typos and errors the artificial intelligence did not pick up correctly.
