In this episode, I am joined by JD Gardner, founder and managing member at Aptus Capital. In his time in the industry, JD has served in the role of associate financial advisor, analyst to a deep-value equity fund, and analyst at short-term, systematic, managed-futures fund.
These varying experiences have mixed to culminate into JD’s ultimate philosophy: it’s all about the investor’s return, not the investment return.
I like to say, “No pain, no premium” as pithy shorthand for the notion that long-term outperformance requires short-term pain along the way. For JD and the team at Aptus, their funds are first and foremost governed by the question of achievability. For them, the contest is not in the theoretical purity of your factor exposure, but rather whether the investor can stick around long enough to harvest it.
A theoretically sub-optimal solution can be best if it helps the investor bridge the behavior gap.
In light of this philosophy, the team at Aptus has launched two strategies. We discuss their Fortified Value index, one of the more unique spins on value investing that I have come across. Not only does the strategy aim to employ a measure of value that leads to greater investor returns, but it also rolls out-of-the-money put options in effort to protect the portfolio against sudden, short-term declines in value that may otherwise invite client misbehavior.
Classic Graham and Dodd value this is not. But for some, JD argues, a much more achievable alternative.
Transcript
Corey Hoffstein 00:03
Hello and welcome, everyone. I’m Corey Hoffstein. And this is flirting with models, the podcast that pulls back the curtain to discover the human factor behind the quantitative strategy.
Narrator 00:15
Corey Hoffstein Is the co founder and chief investment officer of newfound research due to industry regulations. He will not discuss any of newfound researches funds on this podcast all opinions expressed by podcast participants are solely their own opinion and do not reflect the opinion of newfound research. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of newfound research may maintain positions and securities discussed in this podcast for more information is it think newfound.com.
Corey Hoffstein 00:46
In this episode, I am joined by JD Gardner, Founder and Managing Member at Aptus capital. In his time in the industry, JD has served in the role of associate financial advisor analyst at a deep value equity fund, an analyst at a short term systematic managed futures fund. These varying experiences have mixed the culminate into jadis ultimate philosophy. It’s all about the investors return, not the investment return. I like to say no pain, no premium. As a pity shorthand for the notion that long term outperformance requires short term pain along the way. For JD and the team at Aptus. Their funds are first and foremost governed by the question of achievability. For them, the contest is not in the theoretical purity of your factor exposure, but rather whether the investor can stick around long enough to actually harvest it. A theoretically sub optimal solution can be best if it helps the investor bridge the behavior gap. In light of this philosophy, the team at Aptus has launched two strategies. We discuss their fortified value index, one of the more unique spins on value investing that I’ve come across. Not only does the strategy aim to employ a measure of value that leads to greater investor returns. But it also rolls out of the money put options and effort to protect the portfolio against sudden short term declines in value that may otherwise invite client misbehavior. Classic Graham and Dodd value investing this is not but for some JD argues a much more achievable alternative. JD, thank you for joining me today.
JD Gardner 02:34
Thanks for having me. Excited to be here.
Corey Hoffstein 02:36
So JD, you were a college basketball player. And I want to start with the heavy hitting questions. Maybe the only question that will really matter in this podcast, which is who is the greatest basketball player of all time? Michael Jordan. Or Bugs Bunny from Space Jam,
JD Gardner 02:54
clearly bucks money from Space Jam, but I’m going with Jordan. There’s no questions asked Jordan over LeBron. Yeah, I got a couple guys in here who might argue with me on that. But it’s Michael Jordan.
Corey Hoffstein 03:06
All right, you’re gonna have to give me some backup here. Because there’s going to be a lot of angry podcast listeners,
JD Gardner 03:10
I realized that and I’ll give you a little bit of evidence to support it. I think LeBrons body of work is becoming more and more impressive. But I’ll boil it down to if I’m in a game seven. Don’t want LeBron on my team or don’t want Jordan. And if you just look at Jordans body of work in that type of situation, give me Jordan, just Kobe enter the equation. You know what? I am a Kobe fan. I wasn’t a huge fan early on. But I think Kobe and Jordan have kind of the similar killer instinct that I don’t think LeBron has, I’m sure he probably won’t listen to this podcast. So I don’t want to offend him. But Kobe and Jordan both have that kind of let me make it happen. Give me the ball. And I like that
Corey Hoffstein 03:49
killer instinct. Well, now that we got the most important question out of the way, let’s move on to background my friend. So maybe you can take us back to the early days of how you got interested in finance,
JD Gardner 04:02
that takes me back really to always knew that I was gonna go the path of finance at some point. I got really interested in the stock market my freshman year of high school. So unfortunately, and fortunately, I was focused exclusively on basketball, I was probably like other basketball players thinking, well, I’ll just focus on this, I’ll be able to make some money playing basketball at some point. And I really won’t have to worry about all the other stuff. So I just went to school, focused on business, and was lucky enough to get in front of a few professors that really kind of changed the course of how things would play out and they pointed me towards certain things like the CFA, which there was that general interest and it took me down a path to where gotten me here today.
Corey Hoffstein 04:48
You actually did your CFA and MBA while still at school, right or at least started the CFA track. Yeah,
JD Gardner 04:55
what happened is so I started at a school in North Carolina, UNC Wilmington and The head coach that recruited me there took a job at Wright State in Dayton, Ohio. So I transferred with him. And when you transfer from D one to D one, I think this role may be changing, but you have to sit out a year. So I had basically a full redshirt year. And it was in that I happened to have surgery on my foot at the time. And so I had this kind of this window where I really wasn’t playing basketball because of the surgery. I was recovering from that. And I couldn’t play basketball, even if I didn’t have surgery. And that’s when that’s when I had a professor say, Hey, have you ever heard of the CFA and started down that path, and I was able to do, like, started my MBA finished my MBA while I was on scholarship there, which is, I would not have done that if it hadn’t been for the professor and was actually able to knock out the first couple components of the CFA while I was still young and had no clue what I was doing.
Corey Hoffstein 05:54
You’ve told me a couple of great stories in the past that even before you took these classes, you had dabbled a bit in the market. And ultimately, you even were able to buy your wife’s wedding ring. I don’t know if she knows this, maybe she won’t. I don’t know if she knows this story. But you actually bought your wife’s wedding ring through a penny stock trade.
JD Gardner 06:14
Yep, that’s a good one. Another one that chalk it up to 100% luck. So where I lived was about a mile from the office or not the office in our practice facility. And I had an E trade account at the time place to trade for this penny stock. Because I thought that this was during the middle of the financial crisis, when everything there was volatility everywhere. So ways to trade, gotten the truck, row to the practice facility practice showered up, and there was a little computer sitting in the back room. And I was like, well, I’ll just check, see what’s going on. And I bought the thing, like, I can’t remember, like 20 cents, 19 cents, somewhere in there. So, and I looked at it, it was like at $1.50. Just crazy move. And so I was like, well, shoot, I’m gonna sell that. And I got this idea that I think I’m gonna ask my wife to marry me. So let’s just stash this away. And so a lot of her wedding ring, or engagement ring was from a ill advised mini stock trade that worked out.
Corey Hoffstein 07:14
Turning Good luck into better fortune. So after getting out of college, you started working with a financial advisor. Can you take me back to that first career out of college first job, and what you were doing and the analyst role you played?
JD Gardner 07:33
Yep, definitely, I was really fortunate to work with a guy that I owe a lot to right out of school. And he kind of threw me into the fire in terms of got to work with really high net worth families focused on a lot of manager due diligence, especially in the alternative sleeve. Asset allocation when it came to more plain vanilla long, only stuff. And so it wasn’t like I was moving from the textbooks into a $40 million relationship, less don’t mess anything up. So the pressure was on. And that obviously you want to be sure that what you’re doing what you’re recommending, makes a lot of sense. And I was level two CFA at the time with a master’s in finance, which all of that is great. But I really had no real world experience. And my first role, there was probably exactly what I needed at the time. Not only was I having to get in front of people, and having to carry on conversations and figure out how to communicate. But I was also doing a lot of stuff that I was passionate about, which is what the heck is this alternative guy doing? Let’s check it out. What is this dividend focus long only got doing, I get to dig into some of the details and found out what I liked about it found out what I didn’t like about it. And that was a great foundation that was being laid that I wasn’t aware of at the time,
Corey Hoffstein 08:51
I’ve often found the behavioral finance lessons really hit home when you see them firsthand. And a lot of portfolio managers that I’ve spoken to that have actually spent time on the advisory side can often speak to that very deeply that they see these behavioral foibles over and over again, with their clients. And I know, in conversations with you, that’s been a very important catalyst for ultimately shaping Aptus. Maybe you could spend a little bit of time talking about some of the things you saw on your time on the advisory side of the practice, and the behavioral errors that you witnessed.
JD Gardner 09:32
This is a big subject for us. Obviously, we’re focused a lot on how can you help steer behavior to where you’re truly going to enhance outcomes because the biggest detriment we really feel is behavior and everybody. It’s kind of like one of the hot words right now behavior, whatever. And everybody talks about it talks about behavior gap and things like that, but it’s a real problem. It’s a problem that we’re aware of, but I still don’t think enough is done to really address it and to minimize it. And your exact If you’re right, I came into the world, the real world extremely green, I had a decent amount of education behind me. But I’m coming into the world kind of at the tail end of the crisis, where you can take your picture perfect portfolio, and basically rip it up because he motion ruled, like what I think it always does. And the best laid plans were getting ripped to shreds because the world was coming to an end, or that’s on the retail client side and the advisor. And so that was the lightbulb for us. And the foundation of Aptus was really, hey, this is an issue here. Why is this so powerful? Why is this so detrimental? Is there a way that what can be done to help minimize this? And that’s, you know, you can walk through example, one after the other of just seeing what makes sense on paper not actually happening? Because it doesn’t feel right.
Corey Hoffstein 10:56
Today, you’re trying to control a lot of those behavioral issues at the asset management level. And we’ll get into that a bit later. But were there any lessons you took away from working at the advisor level and the client level? Any I don’t want to say tricks of the trade unnecessarily, but anything that you learn that was particularly useful and efficient at controlling and helping guide client misbehavior?
JD Gardner 11:22
Yes. And this will tie into more discussion, I’m sure. But from the advisors seat, I think it’s extremely critical to have conviction and process that requires either somebody that can help with that conviction, or time and energy to build that conviction. So that conviction is what helps you communicate to the end user. And what helps you minimize some of the pushback that is inevitable when markets get volatile. So the first thing that I think now is education and all that type of stuff. But do you have to have conviction with the person that is kind of the point, man, that is how you start to chip away at the behavior gap.
Corey Hoffstein 12:05
You spent about three years on the advisory front, but did ultimately transition to a more research driven role. Can you pick up the story there, pick up the thread about what you were doing. I believe it was a deep value research role, which again, not quite where you’re at today. But maybe you can tell us a little bit about that role, the sorts of research you were doing and lessons learned,
JD Gardner 12:31
I’ve really been fortunate from some of the experiences that I’ve had, that have been great at giving me an idea of what’s out there, and where I think we could improve on certain things. So I got out of the wire house community just because it’s not for me, and some of the things you have to do on top of what you really want to do. I wasn’t a huge fan of. But I took a job to really get into the back office because I wanted to be in the spreadsheets, I wanted to be looking at individual equities, I wanted to be figuring things out. And so I worked with two charterholders that have a really sound process when it comes to valuation, both on the macro front, I was running a lot of economic models looking at at high level stuff, whether it when it comes to the economy and the world economy. And that was a world that I really hadn’t touched before. That was really helpful got to learn how to do cool things with different databases and things like that. But I was also doing deep dives on individual equities. So they’d say, Hey, we’re interested in this space, here’s 20 names, filter it down to five, and we’ll take it from there. So that type of work with some of the models that they had built, seen kind of how they saw the world and how they approached it open so many ideas and questions that I was able to run down and kind of find the answer myself for
Corey Hoffstein 13:52
I often find in speaking with different analysts and portfolio managers that their their process today and their beliefs today are very heavily influenced by their experiences. Can you take me back to some of that work? You were doing some of the models they had built around some of these single equity names? What kind of analysis were you performing? And how has that influenced your thinking today, either positively or negatively about how you approach the investment equation?
JD Gardner 14:25
One of the things that was frustrating, not only from an outcome standpoint, but also just a communication standpoint, you could do the best job of any analyst on the face of the planet and pick a name because this this and this, all these things is a great business, the markets mispriced Well, the market can miss price it further and for a whole lot longer. That was something that really struck me was, hey, this is not repeatable. And to still you’re saying no pay no premium. The whole idea is no matter how sound the process is, if you don’t have an end user that can sit through the process. That’s an issue. That’s the behavior gap in itself. So what I saw and what I took away from that was, that’s where I started, this thing needs to be more systematic needs to be more rules based, it needs to be less, take out the subjectivity, as much as possible. And that’s what some of those individual names, you walk away feeling like, I should put all my money in this is perfect. And then six months later, and you’re like, well, it’s down another 20%. Doesn’t make sense. So it’s just hard to be consistent, consistently accurate, and consistently good when you’re really trying to outsmart 1000s of other folks that are definitely smarter than me.
Corey Hoffstein 15:47
So I know at the time, you were working at this deep value firm, you also got introduced to a totally different way of investing. You had your hands dirty, doing single name, equity research, really deep value. And then it was actually through your mother, you told me that you got introduced to a purely systematic, I would almost color it as a global macro investor. Can you tell us that story?
JD Gardner 16:18
If you can imagine the world that I was in, on a typical day, I got introduced to the complete opposite world. My mom actually taught she taught for 30 something years at a school in Birmingham. And one of her students, she called me up, this is like 2010, probably she says, maybe 2011, somewhere in there. Hey, one of my students has looked like his dad has an interesting bio in the investment space. I’m like, All right. Well, he’s in Birmingham, Alabama. I feel like I know most of the folks do anything interesting in that space. Yeah, who is? And so I did a little bit of background checking. And I said, Yes, I want to meet this guy. And she connected us. And what he was working on at the time, was short term, systematic managed futures trading, trying to actually build the system to do that. So I met with him a few times got to know each other got to learn a lot about what he was doing. And finally, that turned into, Hey, would you help me out with this. And so you’re talking about getting into actually building the system, using all different types of trading platforms and trading tools and scripting and coding and everything else. And like I said, that is a completely different world. And that’s where the power of the idea that I had the devalue shop is, hey, this needs to be more repeatable, how can I be more consistent with this? Will all of a sudden, I’m introduced to this world where it’s like, hey, there’s gonna be no subjectivity to this, it’s going to be completely rules based, the only thing we’re doing is what the system does, obviously, we’re building the system. And so we got into a lot of that was a really fun time. And that’s kind of what ramped everything towards the artists of today,
Corey Hoffstein 18:02
Charlie Munger is very famous for this idea of having different mental models, right, exploring the world in different ways, so that you can approach a problem through many different lenses. When you have the background of deep fundamental analysis, and then you enter this world of purely systematic, somewhat technical, quantitative trading, a lot of people would consider those ideas to clash pretty dramatically. And I know ultimately, at Aptus, you’ve tried to find a bit of harmony between the two. But maybe you can talk about in those early days, were there ideas that you took from the systematic approach that influenced the way you were doing your more fundamental research? And was there ways in which the fundamental research process that you were using helped influence some of the technical and systematic trading that you are performing?
JD Gardner 18:55
Here’s what I took from it all, really, the biggest clash? Do I think fundamentals matter? Yes, I do. Do I think there’s factors that are really important to have exposure to for sure value, momentum quality, all the list? Those things matter? But the counter idea that is, how much do they matter? Or do they matter more than the system that’s in place? And my answer is no, they don’t. They do not the system is what matters. And yes, we could get into some arguments on this for sure. But if you’re gonna get exposure to the value anomaly, if you’re gonna get exposure to momentum, if you’re gonna get exposure to you name it. It’s not value. It’s not momentum, yes, you should be tilted towards those things because of the evidence that supports it. But the system which you put in place to do it is what? It trumps everything. I could have my six year old daughter pick stocks, and if she has a system that consistently wins bigger than she loses, she’s going to create wealth using the market. And that’s what drives everything.
Corey Hoffstein 19:55
I’ll take your segue where I can get it. There was a blog post you wrote and it was The only stock market quote that matters. And you had this phrase embedded in there asking the question of the system, does it win bigger than it loses? And my first question is a, where does that come from? Where did that philosophy come from? And be? Can you explain what that philosophy really means? So what
JD Gardner 20:21
do we know about the market? That’s really, you can’t dispute it? What are the few simple simple truths about the market that we can boil down to? It’s really just plain Jane, here’s the facts. Well, how do you build a system that touches different components of the market that’s always going to adhere to those simple truths. And those simple truths are, if you just own the market, in general, I would argue, you’re going to create wealth, if you just go by the spa, you’re going to create wealth. Well, if you look at this by going back to his launch date, or whatever, like, well, what has generated those gains? Well, those gains have come from a very small number of stocks that have moved the needle in a big way. You’ve had a lot of companies go out of business, you had a lot of companies lose market cap, you had a lot of companies do all things that are not positive to the outcome, but the needle still moves, because you’re gonna have a few names that win so much bigger than all the other losers combined. So everything that we do, whether it’s tilting to different factors, or anything, the system is built upon, can we win bigger than we lose, and still deliver the factor exposure that we’re trying to deliver. And some of the background that ties into that is, when you’re building short term, systematic strategies, like nothing else matters other than the size of your wins to the size of your losses? If you’re going to be 40 to 60%, right? Well, if you do the math, if your ratio is one, for one, I’m gonna win one, I’m going to lose one in terms of size of p&l, you’re really not moving the needle at all. But if you’re at four to one, you could bet 30%, and you’re still moving the needle. And that’s really like the foundation of what we mean by win bigger than you lose.
Corey Hoffstein 22:08
What do you think is ultimately more important for investment success? The size of your winners to your losers? Or the accuracy?
JD Gardner 22:21
Yeah, so two thoughts on that, it’s definitely more important the size. So the simple way, what we say all the time, is control your losers. So try not to ever get your face ripped off, that’s going to impact everything else. And then let your winners go. Let your winners run, don’t penalize somebody from generating wealth. The other thing like this idea, as simple as it is, think about all the different types of investing. This is the definition of what they’re trying to do. They’re gonna throw, really ETF issuers take a big ETF issuer, it’s the same idea. Hey, Cory, you got 10 different ideas for ETF? Sure, let’s launch all 10 Let’s hope one sticks. And by the way, if one sticks and goes to a billion or more, we’re gonna be profitable, even if the other nine go out of business. And so that idea is really, I think it’s true in pretty much everything, especially even when you look at the deep, deep value fundamental stuff like that’s the same idea, you got to be sure that the size of your winners is much bigger than your losers.
Corey Hoffstein 23:22
And moving from the field of single name equities, to the field of futures, where you can suddenly trade not just equities, but multiple geographies, multiple asset classes, rates, currencies, commodities, equity indices, it would appear that there’s a lot more opportunity for diversification. Can you talk to me a little bit about how you see the role of diversification playing into portfolio construction,
JD Gardner 23:55
diversification is the most overused word in the financial world. So really, were this idea one thing, especially in the constraints of like a long, only allocator. True diversification is nearly impossible. I mean, if you if you said, Hey, I’m going to put together we’re going to have eight asset classes, and they’re gonna have zero correlation. We’re going to be long only in all eight asset classes. Let’s rock and roll like, that sounds great on paper, and you’re going to dramatically reduce risk and drawdown and everything else. But that doesn’t exist in a long only context. So were kind of my ideas around diversification started to flesh out was in the future space. Well, you can trade 40 markets in the future space 40 different contracts and you realize quickly, you might have eight trades on at once you really have one trade on how much rates impacts currency, how much equities impact, it’s all inner correlated. And so that goes back to one of the ideas. Okay, true diversification doesn’t necessarily I mean different asset classes, it does mean the system and the return risk profile that that system delivers.
Corey Hoffstein 25:06
So you guys launched ultimately have launched two ETFs, to track indices that you power, your behavioral momentum index as well as your fortified value index. And I want to spend a little bit of time talking about the ladder, because it’s maybe one of the more curious interpretations of value and portfolio construction that I’ve come across. Before we dive into the details, I was hoping we could take a step back, and maybe you could give me some thoughts on the way that you see the value landscape. Whenever I talk to value investors most consider themselves to ultimately be disciples of Graham and Dodd. But just like religion, there’s all sorts of different denominations that appears. And so I wanted to get your take as to my presumption is ultimately you are in in the church to Graham and Dodd. But how do you see the landscape of different value investors and different approaches in? Where do you fit in that landscape
JD Gardner 26:10
in the space that we’re in, like, we’re not walking into state X, Y Z’s Retirement System, and getting a sleeve of an allocation that they’re not going to touch? For the next five to 10 years, like we’re walking into financial advisors offices that are dealing with investors that have different types of needs than kind of a really extremely long term, pension or whatever it is. So with that said, the issue that value brings to the table is its payoff, the premium and the value anomaly can put the asset manager through periods of extreme underperformance. Not like six months, seven months, eight months, but like five years, look at value here since 2009. That makes it really your process and the evidence and everything could be spot on. But if you don’t generate results, that can keep an investor sitting there, it’s going to be really difficult to enhance outcomes. So that’s really what we’re trying to do different is we want to lean you towards value for sure. But the system that we want to put in place, we want it to be something that is going to minimize the periods where we could look like complete idiots now we’re still we’re going to deliver active share and different from a benchmark and still look like idiots. But we’re hoping to minimize the periods that that’s the case.
Corey Hoffstein 27:34
So JD starting high level here. Can you explain for me what the fortified value strategy is
JD Gardner 27:41
fortified value strategy in a nutshell, is we’re trying to tilt equity exposure towards value and quality characteristics, overlaid with the true tail hedges that has potential to protect in a sharp equity drawdown.
Corey Hoffstein 27:56
When we evaluate portfolios in the investment industry. We’re seeing fully baked portfolios. But I’m always curious about the origins and evolution of an approach because my presumption is you didn’t wake up one morning and have the fortified value index methodology fully fleshed out. Can you explain or explore for me? What sort of the inception of the fortified value strategy idea is? Where did it come from? And how did it evolve over time,
JD Gardner 28:31
our idea was to launch two ETFs at the same time, or two strategies at the same time, that worked really well together from a risk management standpoint and an underlying basket standpoint. We launched BMO first, because we thought, Man, this is different. There’s not a trend following momentum fun that does this and that. So let’s launch that. And then once we have some success there, hopefully we’ll get to a point where we can launch another fund. And that will be four to five value. So I guess the origin really was, that was the incentive was to launch them at the same time as a pair. But what we couldn’t wait to get fortified to the market for is because it’s a true play on if we get a sharp rise in volatility. Four to five is gonna look really strong.
Corey Hoffstein 29:19
Can you outline the process of the four to five value strategy for me? Because again, I think it is one of the more unique value strategies that I’ve come across.
JD Gardner 29:31
Yep, we’re going to own 50 stocks, it’s going to come from basically the largest 1000 based on market cap us listed equities. So you’re looking at mid to large cap names. We look at three metrics to build what’s called like our value composite. We’re looking at a flavor of return on invested capital. So we’re trying to basically say what assets are on the books that are used to generate cash flows. How efficient are they A with those assets. Let’s compare that to the rest of the universe. And one of the other components that we look at is cashflow at enterprise value. We think that brings kind of a tilt towards value along with the initial screen value and quality, that makes a lot of sense. And then the third thing that we look at that is really, we hadn’t seen anything else like it. And it makes us kind of tilt, not necessarily towards true true value. But we look at P E ratios relative to itself. So how to explain that is like, take a stock, take apple, I’m making these numbers up, I don’t have anything in front of me. So Apple is trading at a P E ratio of 20. Right now. Well, we’re gonna take a snapshot over the last five years and say, show me where the lowest P E Apple has traded at over the last five year period. And if the closer the current number is to the lowest of the last five years, the higher it’s going to be ranked. So what that does, if you think about it, it doesn’t get us out of the running of stocks, that they may have an extremely high P E, but they’re trading at a discount to what they have been trading at. And if they bring the other two things to the table, they’re going to be included. So we look at that every quarter. And we rebalance based on those metrics, but also on what have you done for us. And that’s a big difference there too, that I know we’ve touched on.
Corey Hoffstein 31:23
So there’s a lot to touch on there. But your use of P E to relative historical PE strikes a chord for me, for two reasons. First, is that one of my very early career explorations was in the space of utilizing fundamental metrics to develop a value and quality screen. And that was actually one of the avenues I explored metrics versus their mid to long term historical averages and found it to have a surprising amount of explanatory power now, that was analysis I performed over 10 years ago. So I’d have to go back and really look. But it was one of the surprising metrics that I found an incredible amount of consistency with. But it strikes me as a metric that can potentially tilt you fairly far away from this traditional deep value notion that you could end up owning securities that are trading at maybe a discount to their own historical average, but at a premium much above the market. Do you have any concern that that approach can ultimately dilute the amount of the value premium that you can capture,
JD Gardner 32:45
think about the hoppy stocks of today that are doing unique things? Think about Amazon think about companies like it. Obviously, there’s nothing like Amazon, but companies that are kind of disrupting whatever sector they’re in. Today, the market said 25, they’re trading at a 200 P E ratio. Okay. But their growth is so much greater than everything else, like I don’t think anybody can look at definitely Amazon. You can’t put a price on Amazon. There’s no idea what Amazon’s worth because they’re doing things that have really never been seen. So I’d ask you what’s the greater risk own in Amazon at a high P E, or a stock like Amazon because it hoppy. We’re not own an Amazon over the next 20 years. Those are the types of companies that for whatever reason, if they deliver on the first two, and they back off on the E for whatever reason, there’s value, there might not be the textbook value definition. So that’s a big rabbit trail I just went down. The bigger question that we ask is, can we rank stocks, like we’re ranking stocks, and then build a system around that ranking system? That is going to accomplish what I keep talking about, which is our wins are going to be dramatically bigger than our losers? That’s a bigger question to ask. I think. So let’s
Corey Hoffstein 34:01
ask that question, then. How do you build a system around the way that your ranking value to win bigger than you lose?
JD Gardner 34:13
I’ll ask you a question. What is the objective?
Corey Hoffstein 34:15
This isn’t your podcast? You don’t get to ask me questions.
JD Gardner 34:18
Well answer this one question, fairly simple question. What is the objective of stock market investing? If you’re gonna buy a stock, what are you trying to accomplish?
Corey Hoffstein 34:26
Well, I think it depends for most investors. But what I would argue for the vast majority of investors that I deal with it is to outpace inflation, and have their money work for them so that they can ultimately
JD Gardner 34:38
retire. So we’re trying to create wealth here. If that’s the objective is going from here to here, which nobody can see me so I did my other hands higher than the firsthand or do what you’re trying to move. Move the needle in the right direction. What we really do that I think is different is take a true momentum fund that rebound Just quarterly, or take a True Value Fund, let’s say value, a true value fund that rebalances quarterly. Well, every single quarter, what typically happens is, hey, they’re delivering value, because the evidence to show that it tends to outperform over whatever time period, because of the analysis, all that stuff, okay, every single quarter, when you go to rebalance, what’s focused on is just the value exposure. So that you shouldn’t be lower turnover and all of those different things. But what we do that’s a little bit different, before we focus on the value exposure, we focus on p&l of our holdings. And how can we still deliver the value exposure we’re trying to deliver, without shooting ourselves in the foot in terms of our winners versus our losers, we’re going to give our winners enough room to run. So if we’re going to buy you at 25, and you go to 50, again, I’m a momentum guy, I would argue that there’s a good chance that that 50 is going to turn into 75. There’s a reason you went from 25 to 50. And let’s don’t get in the way of that. Let’s don’t chalk up our wins and say, good job, we doubled. Let’s roll. Now, obviously, if the other metrics that we look at does not support that type of growth, you’re probably gonna get cut. But we just don’t want to run it run a quarterly rebalance, where we’re just cutting all of our winners and holding all of our losers, we want to be sure that our system is taken into account, hey, let’s don’t penalize this position for doing what the objective is creating wealth.
Corey Hoffstein 36:35
So that strikes me a bit like DFA, who doesn’t use momentum outright, but uses momentum to inform their trading, I think they call it delayed trading, where they won’t buy a value stock. If a value stock enters their screen, but has really poor momentum, they might delay the purchase. And similarly, if they have, I believe, similarly, if they have a value stock that’s got incredibly positive momentum that is now out of their screen, they may delay the sale. And it sounds like you are taking a very similar approach to not explicitly take a momentum bet, necessarily, but to have momentum, inform your ability to earn an asymmetric payoff,
JD Gardner 37:23
as long as you’re within a certain threshold of how we’re initially building the value composite, you’re gonna stay put, and most likely, if you scored worse than you did last quarter is because you created wealth, well, we want to be sure that we give you enough room to create wealth, because Because ultimately, all we’re really trying to do is enhance outcomes. And we’re trying to do that through managing downside, and outside participation. And the combination of what we’re doing is designed to accomplish that.
Corey Hoffstein 37:48
It strikes me that the PE versus relative PE metric could, again put you in a lot of securities that perhaps are not the textbook definition of value, but might be securities that investors are more aware of, right, you mentioned something like Amazon, I can imagine something like Facebook, Netflix, Google going through periods of cyclical decline and becoming attractive on that screen, somewhat allowing you to introduce more of a mean reversion airy play almost not true textbook value, but sounds a little bit more mean diversionary in nature with a value tilt. But I have to imagine that your portfolio may look and appear less suicidal, and then a lot of other value strategies. And maybe there’s a behavioral benefit to that.
JD Gardner 38:50
Yes, I think there is a behavioral benefit. And perfect example, Facebook a few weeks ago, when it had some bad press and all that kind of stuff when we ran a rebalance. Facebook was not included, but it was really close. Some of the other names, they’ve got too much momentum to be included. But that’s a perfect example. And I do think now if you look at our basket, there’s some companies that you just, especially in the retail space, that it just doesn’t look pretty. But there’s also a few names that are like well, that’s not I wouldn’t consider that a true value play was out in there. So it is a good again, it goes back to there’s behavioral benefits in that. I mean, you could rattle off multiple value managers that saw huge outflows when value was way out of favor and huge inflows when value was big in favor. And the argument to that or not the argument but just the point to make and what we harp on all the time is a strategies return is much less important than investors return while exposed to the strategy. And despite as much education as much communication as possible, if you go through a three, four or five year period of looking bad, there’s not a lot of investors that we’re going to deal with that are going to say, hey, Cory, you’ve compounded at seven, when the markets compounded at 15, I’m sticking with you, man, thank you really smart. And now what they typically do is they pull the plug and then all sudden, you compound at 12, when the mark compounds at two, they miss all that, which is obviously the creation of the behavior gap. So how can we avoid that that’s really what we’re trying to do.
Corey Hoffstein 40:28
I want to pivot to what is perhaps the most intriguing part of this strategy, at least to me, which is this put option overlay that you employ. My presumption being that is where the fortified part of the name comes in. But you actually, within this strategy, overall, a fixed amount of put options, I believe it’s 50 basis points, every three months that you’re rolling 20 to 30%, out of the money, I’ll let you correct me if I’m wrong in effort to protect the portfolio against quick and sudden sell offs, I presume, which is a pretty unique approach, you don’t see that in your traditional, quote, unquote, smart beta value strategies. So I was hoping you could talk a little bit about the inception of that idea and where it came from, then how you think about designing that aspect of the portfolio
JD Gardner 41:28
turn falling is going to look really good in a prolonged downturn. The problem with trend following especially when you splash a heavy dose of momentum in it is well, so my pulls the rug on the market. And you get this quick swoosh down. You’re fully participating in that until your trend following signal kicks in. And just
Corey Hoffstein 41:47
to be clear for listeners, that trend following plus momentum is what you do in your behavioral momentum index.
JD Gardner 41:53
So the idea is not only a complimentary basket, but also risk management. So that’s where the tail hedging came into play. And so what we do is exactly what you said, we buy puts on the market that from the high level view, people probably think we’re just taking 50 pips and throwing it out the window. But in that premium, the price you pay for those puts, there’s five ingredients, obviously, one of the big ones is volatility. And so the level of volatility is going to impact the premium, when the level of volatility is low, your potential protection is going to be much greater than what it would be if volatility was high, because you’re picking up more, you’re getting more bang for your buck. So the very simplified the way of thinking about a true tail hedge is you bought something for really cheap, that looks like it will never do anything positive for you. And as soon as volatility wakes up, the premium in that could explode. That’s what a true tail hedge is
Corey Hoffstein 42:56
the intuition there being that it’s easier for the market to drop 50% when volatility is at 20, than it is when volatility is at five.
JD Gardner 43:04
Yes, exactly. So when you buy all options have a time to expiration. So if you buy an option, I’m making these numbers up the premiums $1. And it expires next year, 12 months from now, well, if nothing happens to the underlying security that the option is on, and you move out in time, three months, absolutely nothing has happened will the premium, you’re still going to lose money in that premium, because there’s going to be some time decay, because there’s less time so the option is less valuable. So when you’re looking at puts that we’re looking at far out of the money, the market knows if you look at this as another interesting topic, but if you look at the distribution of returns in the market, there’s a big fat left tail. So everybody’s probably remember stats one to one, the normal bell curve. Well, the market returns are not normally distributed. There’s a huge left tail, meaning the market is aware that a left tail event a big negative event is more likely than a right tail event. So for that reason, where we’re buying in the time to expiration, and out of the money, you get a little bit of, I guess relief from that time decay, because you’re going to get the volatility is going to naturally creep up as you get closer and closer to expiration. And that helps us with, hey, if the market just rips straight up, we want to be sure that we’re not forfeiting a lot of the upside. And really what we want the tail hedge to do is to be a significant offset to a significant drop in price. So if the market were to drop 20% Over the next 30 to 60 days, we want our tail hedge to maybe not offset US dollar for dollar, but really kick in to minimize drawdown. And what happened in early February that day, the market dropped 4.2% We had a complete reset of volatility across the board. And so we anticipate a certain level of volatility conservatively in our models. that if you were to drop 20% Over the next 30 to 5060 days, where would we expect volatility to be? And how much offset would our hedge give us? Well, in a matter of like two hours in early February, volatility went from where it was, to where we expected it to be over a 30 plus day window. And so our fortified strategy went absolutely bonkers. You saw this little 50 bits of the account wake up to be not 50 pips anymore. And so we actually profited significantly on that day,
Corey Hoffstein 45:35
I’m going to turn up the heat a little bit, turn it up. There’s an AQR paper, titled the pathetic protection, the elusive benefits of protective puts. And I’m just going to read two sort of summary bullets that they put on their website regarding the paper. The first summary says put options are only effective in reducing drawdowns in the unusual circumstance that the options are priced with no volatility risk premium, and equity drawdowns precisely coincide with the option holding period. Second bullet, put protection can lead to worse drawdown characteristics. When options are priced with a volatility risk premium, which is almost always the case with index options. How would you address these concerns as they relate to the way that you are employing put options in the fortified value index,
JD Gardner 46:30
their concerns will be addressed very simply, in a rising market environment, our active share and concentration give us the opportunity to offset any drag that the options may be. The second aspect to that is if you look at how we’re rolling, the potential drag is going to be much less than what could be anticipated. The second argument is, well keep in mind too, that we have a value dependent to hedge. So in the levels of valuation in the overall market as a whole, we are much more prone to a significant drop in market prices than we would be evaluation was 20%. Lower. So at 20% Lower everything is about probabilities. What’s the probability of A 20% drawdown? Well, probabilities of A 20% drawdown are significantly higher than they would be? If we were at a different valuation? That was much lower? So if we were much lower, would we have the tail hedge on? Probably not. So if the probability for drawdown is high, volatility is non existent, or very, very low, you’re gonna get significant bang for your buck.
Corey Hoffstein 47:39
Alright, so two ideas there, I want to explore a little bit further. First, I really want to unpack talking about this rolling. But before we do that, you mentioned something, which is that the tail hedge is actually valuation dependent. Can you explain what that means? Yes,
JD Gardner 47:54
so we look at first step of the process is we look at the Q Ratio, in terms of the overall market valuation. When we are in the third or fourth quartile of key ratios, the only time the tail hedge will be included. So if we’re not now, and the reason for that, it just goes back to the probabilities of things higher valuations lead to lower returns moving forward and potential for higher risk in terms of drawdown. That’s a bad combination. There’s Goldman’s got a good paper on that. So if probabilities for greater drawdowns and lower returns moving forward, we probably want to have a tail hedge in place. When that’s not the case, you probably don’t want to have a tail hedge in place, because then I would say, Cliff, we agree with you. We don’t need to tell hedge, we don’t need put protection.
Corey Hoffstein 48:41
One of the really interesting things you’ve said to me in the past is that a tail hedge strategy like this may not be as effective in protecting against an environment like 2008, whereas a trend strategy would, but that a hedge like this can actually create more cash for you to deploy within the value strategy. And I was hoping you could explore that concept a little bit, not so much thinking of the hedge as a protection but thinking of the hedge as the ability to get more value exposure at a more opportune time.
JD Gardner 49:18
Thank you for bringing that because that’s really there’s a couple big thoughts here. One is when you look at right now our strategy or two strategies, the baskets complement each other like I’ve said, but also, if trend following looks good and prolonged markets, you want some type of risk management that looks good and a sharp downturn. That’s where the tail hedge comes in place. The way I view tail hedging, yes, there’s going to be some risk management benefits in a sharp drawdown. But also what’s going to happen is you’re going to create cash at more opportune times to deploy capital into equities. So if if the markets reset over the next 30 days down 20 and say we generate did half of that 10% in cash, the footsie went from 50 basis points to temperature the strategy? Well, we’re now getting to deploy 10% of the of the strategy back into stocks that are relatively low P E, generate higher returns on invested capital and have a good cash flow and enterprise value. I’d much rather deploy capital at 20%, lower than I would today. And so that’s what the tail hedge can effectively do.
Corey Hoffstein 50:26
You mentioned that with the tail hedge you are doing this rolling exposure, we never really unpack that. Can you explain the process for which you’re rolling the putts?
JD Gardner 50:37
So where are you going to roll every month, so we’re going to buy three months out, typically, you’re looking at like 70 to 80 days to expiration. And we’re typically rolling somewhere between 5055 days, somewhere in there. So you still have a couple months of time to expiration. And what in terms of out of money, we’re looking typically it’s 25 to 30%. We start at one level, but then we base it on liquidity of what we’re buying. And so 30% is about where we ended up being in terms of out of the money.
Corey Hoffstein 51:13
JD last question for you. And this is a question I’m asking everyone on the podcast. If you were to describe yourself as an investment strategy, you could be value you could be momentum, you could be a low vol. You could be trend following. What would the strategy be and why now I want to be clear here, it’s not what you want to be. almost think of it how would your wife explain you as an investment strategy? What would it be and why?
JD Gardner 51:45
Oh, my goodness, I would say no, this doesn’t have anything to do with our stuff. This is just you’re talking about like
Corey Hoffstein 51:51
me personally. Yeah, you could be convertible bond arbitrage.
JD Gardner 51:55
My wife wouldn’t say this. But if she knew what it was, she might on probably on the liquidity provider. High frequency guy out there just trying to make a little bit here a little bit there, but just nonstop high volume go. That’s probably a terrible answer. But that was the first thing that popped out.
Corey Hoffstein 52:10
I love it. That’s a unique one. I absolutely love it. JD it’s been an absolute pleasure having you here with me. Thank you for joining.
JD Gardner 52:16
Thank you. Appreciate it.
Corey Hoffstein 52:20
I hope you enjoyed my conversation with JD Gardner. You can find more about JD and the team at Aptus capital advisors.com. Show Notes for this episode are available at flirting with models.com/podcast. If you enjoyed the episode, please share it with a friend or on social media. And go ahead and leave us a review on iTunes.