Liquid Strategies Insights & Commentary

At the start of the quarter, the U.S. equity markets staged yet another dramatic rally, sending most global equity markets higher and pushing the S&P 500 Index to new all-time highs. Concerns around COVID, stimulus and elections led to an extremely volatile finish to the quarter in risk assets. Despite the volatile finish to the quarter, our income-based Overlay Strategy generated gross income of 1.42% for the quarter, bringing the annualized gross income produced by the Strategy to 2.94% since inception in 2013.

Net of fees assumes a 0.75% management fee applied monthly.

The Strategy continues to demonstrate the ability to generate positive long-term incremental income to underlying beta sources in a variety of market conditions. For investors that would have been invested in these various strategies since the inception of the firm, below are the illustrative long-term performance results:

ANNUALIZED SEPARATE ACCOUNT ILLUSTRATIVE RETURNS (Net¹)

11/01/2013 - 09/30/2020

 ¹Net of fees assumes a 0.75% management fee applied monthly. These returns are illustrative, hypothetical numbers representative of two actual return streams (Liquid Strategies Overlay and the underlying index ETF). The numbers illustrate what would have happened had we taken the underlying index ETF returns and added Liquid Strategy Overlay returns to them. Source: Morningstar, Liquid Strategies.

OVERLAY STRATEGY ANNUALIZED PERFORMANCE

11/01/2013-09/30/2020

Net of fees assumes a 0.75% management fee applied monthly.

*Hypothetical/Illustrative performance is not an indicator of future actual results. The results reflect performance of a strategy not offered to investors during the time indicated in the analysis  and do not represent returns that any investor actually attained. Hypothetical/Illustrative results are calculated by the retroactive application of the Overlay strategy constructed on the basis of historical data combined with other existing independently-managed ETFs and based on assumptions integral to this presentation which may or may not be testable and are subject to losses. General assumptions include: The manager would have been able to purchase securities in a single portfolio with similar characteristics to the Overlay Strategy and the Index ETFs recommended by the illustration, and the markets were sufficiently liquid to permit all trading. Indexes used for comparative purposes cannot be traded, however there are securities, funds, and similar investments that can be purchased to obtain similar results and include no fees. Changes in these assumptions may have a material impact on the hypothetical returns presented. No representations and warranties are made as to the reasonableness of the assumptions. This information is provided for illustrative purposes only. Actual performance may differ significantly from hypothetical/illustrative performance. Source: Morningstar, Bloomberg, L.P., Liquid Strategies.

Portfolio diversification has long been one of the most important tenets of successful investing. One of the easiest ways for investors to achieve diversification is to invest in funds that are designed to track diversified indices in various asset classes. Using equity-based index funds allows investors to avoid the need to research individual companies, instead allowing them to gain access to some of the most widely-held stocks in the world.

After a historic collapse in the 1st quarter of 2020, the U.S. equity markets staged a dramatic recovery, finishing with the best quarterly return (+20.54% for the S&P 500 Index) since Q4 1998. This strong market recovery coupled with high but falling equity volatility served as significant tailwinds for our strategies, which were able to benefit both from the gains in risk assets as well as gains from our income-based Overlay Strategy. For the quarter, the Overlay Strategy generated gross income of 1.80% bringing the annualized gross income produced by the Strategy to 2.83% since inception in 2013.

Net of fees assumes a 0.75% management fee applied monthly.

ANNUALIZED SEPARATE ACCOUNT ILLUSTRATIVE RETURNS (Net¹)

11/01/2013 - 06/30/2020

 ¹Net of fees assumes a 0.75% management fee applied monthly. These returns are illustrative, hypothetical numbers representative of two actual return streams (Liquid Strategies Overlay and the underlying index ETF). The numbers illustrate what would have happened had we taken the underlying index ETF returns and added Liquid Strategy Overlay returns to them. Source: Morningstar, Liquid Strategies.

OVERLAY STRATEGY ANNUALIZED PERFORMANCE

11/01/2013-06/30/2020

Net of fees assumes a 0.75% management fee applied monthly.

*Hypothetical/Illustrative performance is not an indicator of future actual results. The results reflect performance of a strategy not offered to investors during the time indicated in the analysis  and do not represent returns that any investor actually attained. Hypothetical/Illustrative results are calculated by the retroactive application of the Overlay strategy constructed on the basis of historical data combined with other existing independently-managed ETFs and based on assumptions integral to this presentation which may or may not be testable and are subject to losses. General assumptions include: The manager would have been able to purchase securities in a single portfolio with similar characteristics to the Overlay Strategy and the Index ETFs recommended by the illustration, and the markets were sufficiently liquid to permit all trading. Indexes used for comparative purposes cannot be traded, however there are securities, funds, and similar investments that can be purchased to obtain similar results and include no fees. Changes in these assumptions may have a material impact on the hypothetical returns presented. No representations and warranties are made as to the reasonableness of the assumptions. This information is provided for illustrative purposes only. Actual performance may differ significantly from hypothetical/illustrative performance. Source: Morningstar, Bloomberg, L.P., Liquid Strategies.

In my role, the first thing everyone wants to talk about is my opinion on the markets (and ideally exactly what to buy and sell and when!). These advice seekers usually walk away empty handed in terms of specific investment ideas, but I am always happy to talk big picture in terms of broad risks and opportunities. The only question that I have gotten over the past few weeks is some version of: “Why is there such a big disconnect between the stock market and the economy…shouldn’t the market be much lower?”

After multiple daily moves over 9% in the S%P 500 Index in March (including one down day of almost 12%), market volatility has contracted significantly since the March 23^rd bottom. One way to measure volatility is to look at the average daily moves of the market (regardless of direction) to quantify the daily price swings. In March, the average daily move of the S&P 500 Index was 4.95% (it moved up or down on average 4.95% a day).

While there is much to discuss from a markets perspective, first and foremost we hope you and all of your loved ones are safe and healthy. In previous letters, we laid out a number of potential catalysts for ending the historic bull market and starting a global recession, including the possibility for events that at the time no one could anticipate. COVID-19 turned out to be that great unknown, sending shockwaves throughout the financial system as investors attempted to find the “right” discount to apply to risk assets given the high level of uncertainty for the economy, earnings and even solvency for many companies and industries. The end result was one of the most violent equity market declines in U.S. history, with the S&P 500 Index losing over 35% in just the course of a few weeks, bringing with it historic levels of market volatility. Despite such extreme market conditions, the Overlay Strategy (utilized as an income generation tool within our six main strategies), actually generated a positive 0.37% return for March with the S&P 500 Index -12.35%, and -1.99% YTD compared to -19.60% for the S&P 500 Index. The Strategy continues to demonstrate the ability to generate positive long-term incremental income to underlying beta sources while protecting capital during times of market stress. For investors that would have been invested in these various strategies since the inception of the firm, below are the illustrative long-term performance results:

*Hypothetical/Illustrative performance is not an indicator of future actual results. The results reflect performance of a strategy not offered to investors during the time indicated in the analysis  and do not represent returns that any investor actually attained. Hypothetical/Illustrative results are calculated by the retroactive application of the Overlay strategy constructed on the basis of historical data combined with other existing independently-managed ETFs and based on assumptions integral to this presentation which may or may not be testable and are subject to losses. General assumptions include: The manager would have been able to purchase securities in a single portfolio with similar characteristics to the Overlay Strategy and the Index ETFs recommended by the illustration, and the markets were sufficiently liquid to permit all trading. Indexes used for comparative purposes cannot be traded, however there are securities, funds, and similar investments that can be purchased to obtain similar results and include no fees. Changes in these assumptions may have a material impact on the hypothetical returns presented. No representations and warranties are made as to the reasonableness of the assumptions. This information is provided for illustrative purposes only. Actual performance may differ significantly from hypothetical/illustrative performance. Source: Morningstar, Bloomberg, L.P., Liquid Strategies.

Given the high level of uncertainty regarding COVID-19, it is impossible to estimate what the final market bottom will be. The final low water mark will be a function of a number of factors, including, but not limited to:

1) The availability of widespread rapid testing

2) The development of treatments for patients having an adverse reaction to the virus

3) The timing of businesses reopening to once again allow consumer spending

4) The magnitude of financial and fiscal stimulus to provide relief to our citizens and businesses that are struggling during this shutdown

Liquid Strategies is monitoring the spread of the COVID-19 outbreak, also known as coronavirus. We take seriously the health and well-being of our employees, clients and associates.

While there is currently no health or safety concern within our firm, we want to make sure you are aware that we are taking every precaution necessary. In the event there is an outbreak in our area, we have an emergency plan of action in place that would enable our portfolio team and staff to work remotely and continue to manage all client portfolios.

In light of the historic market volatility that has accompanied this outbreak, we want to update you on the actions we have taken and will continue to take for our overlay strategy. First, and most importantly, our thoughts and prayers go out to the families directly impacted by the coronavirus, both now and in the future. 

The extreme level of uncertainty and fear that has gripped the globe from a health perspective has spread to the global financial markets. Just as health officials are struggling with quantifying the impact of the pandemic, investors are faced with the impossible task of determining the potential financial impact of the virus on all businesses across all sectors and of all size. As such, it is impossible to know how to properly discount future corporate earnings, and therefore how to discount stock prices accordingly. It may take quarters or possibly even years to be able to look back and know the “right” discount of stock prices. This extreme uncertainty around future earnings has driven equity volatility to extreme levels not seen since the global financial crisis and near the worst that we have seen in our careers. This extreme volatility validates risk management as the top priority for our overlay strategy rather than return maximization. The primary elements of our risk management process are 1) defined risk through the use of constant hedging and 2) exposure management driven by our volatility risk model. All our positions have offsetting hedges which set clearly defined maximum losses for each position, protecting the portfolio against the type of gap moves down that have occurred over the past two weeks. These protective hedges proved to be a crucial line of defense during the drawdown. As an additional line of defense, we closely track equity volatility to identify periods where equity volatility is accelerating rapidly, a condition that is unfavorable to most strategies, not just the overlay strategy. Our risk model began to indicate high levels of market risk on February 24^th and has remained in that condition since. This led us to reduce and then eventually close all of our overlay positions, providing another crucial backstop during this period of extreme volatility. The net result is, with losses in the equity markets now approaching 25% from the peak, the overlay strategy has lost less than 2.5% during this period. 

It is impossible to positively determine when and at what level the market will find a short-term bottom, let alone a long-term bottom. Until there is more clarity and volatility subsides, we will continue to execute our strategy with caution by continuing to focus on preserving capital while prudently adding new positions that can benefit from the extreme negative sentiment. 

As always, we are happy to visit with investors anytime to share our thoughts on the current environment.

Sincerely,

Brad Ball, Shawn Gibson, Adam Stewart and Justin Boller

The CBOE S&P 500 Volatility Index (the “VIX”) was given the label as the “Fear Index” decades ago even though most investors do not understand what the index represents or why it was given this nickname. In laymen’s terms, the VIX roughly reflects the expected volatility of the S&P 500 Index over the next 30 days, expressed in annualized terms. 

In a previous blog post (What is an Overlay?), we discussed how investors who utilize overlays do so with the goal of reshaping the potential investment outcomes with the most common goals being:

1. Generating supplemental income/return (typically through covered call or put writing strategies
2. Reducing the risk of the existing portfolio beta exposure (typically through collar strategies)

For investors seeking additional income, it is our belief that the best way to achieve this outcome is through a disciplined put spread writing program that provides investors with a relatively conservative stream of income that supplements the income/total return of the assets in the underlying.