Today's animal spirits talk your book is brought to you by Shelton Capital Management. Go to SheltonCap.com to learn more about their Shelton Equity Income Fund. That's ticker EQ, TIX, which is a Morningstar, five-star and gold medalist rank fund as of 1031-24, or that's SheltonCap.com.
Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Badnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of RIDHOLT's wealth management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of RIDHOLT's wealth management may maintain positions in the securities discussed in this podcast.
Welcome to Animal Spirits with Michael and Ben. Today we're talking about the Shelton Equity Income Strategy, which is a portfolio of, can you say, 100 stocks? Yes. And he's selling calls against the individual securities, unlike some of the
some of the more recent popular strategies that do it at the index level. You know, it's funny as this category has exploded to, I think he's had $120 billion in assets. It's interesting that it did it in an environment where, now listen, these are predominantly income oriented strategies, right? By definition, when you're selling calls, you're giving away some upside, you had a little bit of downside protection depending on the market environment. But the idea is that this is an income strategy, right? And it's sort of ironic that this category exploded
as fixed income was finally offering hiring yields. And we're in a bull market. Yeah. I think a lot of the popularity is due to the fact that 2022 was such a shit year for both stocks and bonds. And a lot of these strategies, depending on the type of portfolio and not only were they delivering income,
They were also, again, not everyone, but a lot of them that were selecting individual stocks had a more value oriented defensive tilt. So it was the double whammy in a good way in 2022. And we know investors chase performance. So I think that that probably was the spark. And then what kept it going was people love their income.
My theory too is that yield is the easiest sale there is in terms of if your strategy is going to be a little more complex than the plain vanilla strategies. And if you're using option, that is a little more complex. Yield is a wonderful selling point for multiple investors understand yield. Oh, this is the yield I'm getting. This is the yield you're targeting. That's why things like private credit, it's an easy sale to people because the bottom line, the bottom line is with this strategy, you use targeting 69% annualized income and people will get it.
Yes. And understand, all right, they might understand exactly how the options work and the fate and the zade and the listen to that, but they understand that I'm getting the income. So the most important point he made, so we talked to Barry Martin today who is a portfolio manager of the Sheldon equity income fund. And he said, listen, when we do inevitably underperform in a bull market, we don't have people blowing out anymore because they understand this strategy. It's simple to understand. And I think that is the big
key point. And I think that's interesting for portfolio managers and retail investors understand it more, but I think I'm sure portfolio managers love it when most of their flow has come from financial advisors. Yeah, stick here. Because financial advisors understand and they educate their clients and credit their financial advisors. All right. So here's our conversation with Barry Martin from Shelton Capital Management.
Barry, we have heard a bunch from our listeners, from places like the Wall Street Journal and other financial publications of the demand for option income funds. It seems like in the last two or three years, this is really a segment of the market that has taken off. Why is that? Why is it the case that these things are so popular these days?
Yeah, it's been crazy. I mean, a couple months ago, the Wall Street Journal came out with an article about it and they called it Boomer Candy, which is yeah, it's good. It's great. Yeah, so it's pretty hilarious. And yeah, I mean, they're at 120 billion in assets. I think last year in Morningstar, it was the second most inflows of any strategy or category. But I think a lot has to do with demographics, right? So
You have these older boomers that are approaching retirement and looking for income, but also alternative income. This is a different return pattern and doesn't necessarily perform your typical bonds or reads or MLPs. It's added to income portfolios and it's just an attractive
attractive way to get cashflow. So you guys have been running the strategy for a long time. Are you like, hey, get off my lawn or is this a rising tide? How do you feel about the sudden popularity of some that you've been running for a long time? It's been crazy. It's been a passion of mine for 25 years. I've been doing it. And you had the ebbs and flows of covered option writing. It's been in favor. It's been out of favor. But right now,
It's kind of like the glory days, I think, which is great for us. I mean, you know, we've obviously seen a lot of inflows, but the returns have done very well. So, you know, I'm excited about it. Also, you know, we're a smaller player in the area, but you see BlackRock, Goldman Sachs, you know, everyone's, but obviously J.T. Morgan is jumping into the pool. So it's confirmation of what I've been doing over all the years. So it's great for us. So I'm really excited about it.
So what are some of the ways to distinguish yourself from these other strategies? Yeah, we different a couple different ways First of all, we're selling individual calls on individual names. So I think that's a big differential So not doing it on the index not doing the index not doing the index we're doing individual calls on individual names I like it because you be more proactive and so we're not
trading options on the Thursday before expiration and sitting on our hands. We're constantly active with these option positions. We have over 100 positions, so it's a diversified portfolio. But the reality is, we can sell options that are further out of the money than an index call because you get more volatility in individual names, so we take more off the table if we want to, or we can write tighter and take more off the table.
But if you look at our upside capture, it's a little bit higher than our competitors. And I think that has a lot to do with us writing individual calls on it. How much flexibility do you have in terms of differentiating between what cause you're going to sell on what stock based on market environment, based on what interest rates and option premium and all that sort of stuff? Is it how much of it is rules based versus discretionary?
Yeah, so it's rules based on the point that our goal is to generate anywhere between six to nine percent in an annualized cash flow target. Nice. So when I'm selling options that are, yeah, so what I'm selling options that are 45 to 60 to 90 days out, I'm looking for an annualized target in that range. And so that's a determinant of the strike that we're going to sell. I also want some upside on the position. So,
We're selling typically options with delta between 30 and 40. What does that mean? Yeah, so delta is a couple of different things, how I look at it. Like a delta of 35 means when the option moves a dollar, the option price will move 35 cents. But I also look at it like when I sell a delta 35, it also means that there's a 35% chance at expiration that it will be in the money. So we're selling options that basically have like a
a 60 to 70% chance of not being called away. So it's out of the money. Something that's at the money is usually a delta of around 50. So that's kind of how we look at it. So we have a balancing act that we're trying to do is between upside of the underlying equities and the cash flow that we're receiving from selling the calls. And are you doing it? So we have 100 positions in the fund. And we're talking about the Shelton equity income fund here. Are you doing it on every holding in the fund? Are there specific holdings that make more sense to sell the options on?
Yeah, so we have options on each one of the holdings. So every position has a call written against it. We're not necessarily trying to tie in the market. You'll see some more competitors take options off, put options on. We're consistently selling covered calls. And how we sell covered calls is a little different from others as well, is that if I have 10,000 shares of Apple, that means I can sell 100 calls.
The reality though is that I don't need to sell all hundred calls to hit our target of six to nine percent. By just selling about 30% of the position or 30% of the calls, I can hit that target. So if I'm selling 30 calls and the market appreciates, I can actually rolling those options. So that means I'm buying the options back and selling more calls on the way up.
So it's a process of basically letting the stock appreciate while also taking money off the table by selling the calls. I don't want to take for granted the fact that people might or might not know what happens when a stock is called away. So can you walk us through how that works? Yeah. When you sell an option, you're selling someone the right, but not the obligation to purchase the stock off of you at a predetermined price.
That was a really good CFA answer right there. That's the definition I learned in the CFA. Yeah, I think Barry said that before. Yeah. So for example, if we can use, you know, use Apple as an example. Apple's roughly around $225 a share. You can sell someone the December 240s and someone's going to pay you for that right to buy it off of you at December at two Friday, which is the third Friday of the month.
So when I sell the option, it doesn't necessarily mean it's going to get called away from us either. So I have this option. I can also buy back that option.
But typically what you do is you wait till the third Friday of December, and if the stock is in the money, that means the stock's gonna get called away from you. When called away means you have to sell the stock or deliver those shares to the person that bought the call from you. And so in most cases, if the stock is in the money, and we wanna keep the stock, we'll likely buy that option back before it gets called away from us and sell another option and roll up the position. So we'll see some upside of the underlying equities by doing that.
I'm curious how you look at your list of stocks that you want to purchase. If you have a stock that gets called away, are you going to be looking to purchase it back right away? Or do you have another stock waiting in the wings to use it as a rebalancing mechanism? How does that process work when you do have some turnover in the fund when these stocks hit your upper band?
You know, when you write cover calls, you have asymmetric returns, meaning that your upside's capped at a certain level, and you have a lot of downside risk. So we really have to be careful about the stocks that we own. I grew up playing tennis, I played tennis in college, and then I coached my daughter through tennis, and now she currently plays tennis in the Big Ten, and tennis is a lot like covered option writing. They say, you know, 80% of points are lost, not won.
Basically, you need to keep the ball in the court. It's hard to win a match by hitting a lot of winners because you make errors when you're trying to attempt a winner. I can't hit home runs. I can barely hit a double because of asymmetric return. We're looking at stocks that have a defensive quality, that are market leaders, and stocks that actually generate free cash flow.
And that basically goes back to when you're looking at equities, you have that asymmetric, or when you're looking at cover call writing, you're looking at that asymmetric returns. Your upside's cap and your blood downside risk. So you really have to manage that downside risk.
So we have a process that basically screening process that looks at underlying equities that have this defensive quality that generate free cash. But also equities that are in a positive trend. I think it's important to look at that as well because our time horizon actually isn't that long. I'm not owning these stocks for 10 years. I could literally only own the stock for maybe 45 to 60 days, right? Because I'm selling covered balls.
So we get called away from us. So we have a ranking process that we created where we believe we're buying the best stocks in the S&P 500 to sell a covered call. So in saying that if a stock goes in the money and we don't want any more gets called away, it'll be replaced with whatever replaced that stock in that quadrant in the each sector of the S&P.
I think people think about maybe you give up some of your upside, your selling calls, and therefore you're going to have some cushion on the downside. To me, I think about these strategies more as an income-oriented strategy as opposed to downside protection, because yeah, if the market's down 22%, I'm making this up. You might be down 19, you're not going to be down 11, right? How do you talk to investors? Well, maybe, though, didn't option strategies do really well on 20, 22?
because that because if you're thinking about like Jepy, for example, like it's a defensive portfolio. Maybe not that one specifically, but some of the underlying names, it was a value oriented portfolio. So it wasn't that the option premium saved investors on the downside. It was more of the nature of the underlying holdings in that portfolio. Barry, am I correct there?
Yeah, so like, as we mentioned, you know, 2022 mark was down around 90%, we're down about 10. And that differential that 9%, it was mainly the option premium. But typically, what I get nervous about, and it kind of goes to your point, is that there are there are option overlay products that do cover calls on the NASDAQ.
I'm not a big fan of that because because the NASDAQ, if I own the NASDAQ, I want the upside. Like I'm buying the NASDAQ for upside. I don't really want to buy the NASDAQ for income. And then it goes to your point is like, you own the NASDAQ and you're running covered calls. You're capping the upside. What do you have? You have a lot of downside risk. Right. And so, so you have to be aware of that. And so I shy away from that. Like, I think
When you're looking at cover call right and he goes, oh, man, I can get 20% for selling this call. Well, well, the reason you get 20% is because of all the vault. And so you're selling away the upwards wall and you're holding the downwards ball. So that's just makes me nervous. So, so you'll see other covered option writers where they stick to like value securities and sell cover calls. I'm a blended portfolio. So we'll have an Amazon in here. We have an video. We have Google, but then we also have
your typical AT&T and stuff like that and value. I think a blended approach is more appropriate. The way we look at it is the stocks that are generating free cash flow tend to perform better in that downward market. I would guess that
With a company like AT&T, you could sell call options that are 10, 15% out of the money over, you know, whatever, a three month, six month period and feel relatively comfortable. As opposed to Nvidia, you know, you give that 10% and it could get called away, you know, in four hours. Like, are you more likely to sell something for Nvidia that's further out of the money? How does that work?
Yeah, so we look at it both ways. We actually, when we look at covered call writing, we actually have an expectations of the old target. And that actually includes the underlying dividend as well. So AT&T pays a nice dividend. We don't need to generate that much more from selling covered calls. The volatility is on the low end. So it's just kind of like.
It's just adding a little to that dividends being paid. Nvidia, on the other hand, you're right. To get 6% to 9% of Nvidia, I'm only selling options on maybe 10% of the portfolio. That hits that target. But you could sell a lot more, take more money on the table. It just depends on what your views on Nvidia are in the market.
Volatility does blow out and you're in a bear market or a correction scenario. You're still sticking in your bands. You're not trying to get greedy. So that just means that it's easier for you to hit those income targets with, I guess, closer options or however it works. Yeah. So if you were, you know, we go back to 2020 with COVID, markets down 30%, volatility blows out of the water expands. And since I'm selling individual calls and individuals names,
At that time, I'm able to sell options that are 25, 30, 35% out of the money and still hit that target of 6 to 9%. That's why I really like writing individual names instead of the index. If you look at the buy-write index, which is our benchmark,
They're selling calls at that lower level and they basically get what we call a website. So market moves down dramatically and it can't go back up because you've capped the portfolio at a lower level. So that's why I like writing covered calls and individual names because I
because there's more volatility individual names and I can really sell out of the money when volatility expands to hit those targets. Because options, the pricing mechanism changes so much. Are you a believer that it's really hard to do this quantitatively or algorithmically then?
No, you can still do it that way. I mean, we're selling options to a yield target. Goldman Sachs did a white paper a while back looking at that. And from a risk adjuster return, it's an appropriate to do it. People have other ways to sell cover calls and sell options and buy options. But I mean, I think there's definitely many different ways to skin this cat.
All right. So Barry, people, people love income and there's all sorts of behavioral reasons why generating income via dividends or options is much more preferable to just doing themselves by pressing a few buttons and selling down their principal. And I, I'm fully on board with that. I understand where it's coming from. So how do investors that you talk to think about the actual portfolio? Like do they, do they care about the total return or is it really just, I need my six to nine percent income?
Yeah, I mean, it's actually becoming more in vogue, I think, because it performs differently than equities and performs, even though it's equity exposure, obviously, but performs differently from fixed income. So we're seeing most of our clients are advisors.
And we're seeing advisors add this to their portfolio. When they had the younger 60-40 portfolio and the death of the 60-40 portfolio, everyone I call it, they're taking 10% of equity exposure, maybe 10% of fixed income exposure and adding this to the portfolio. Typically, our standard deviations around 25% to 30% less than the S&P.
The last three years, because we had that down market, or we've had similar market returns with lower standard deviation. So from a modern portfolio theory, it actually performs really well. I use it. If you want to use an analogy, it's you're flying cross country. And the guy says, the pilot says, hey, we have a storm here and we're going to, it takes 25 minutes to go around the storm, but we'll get there when it's smoother, right? That's kind of how I equate to this portfolio.
But it goes back to your original statement. I would say 80% of our clients use this as a cash flow alternative because it doesn't perform like the bonds, reads, or MLPs. So adding it to that as well diversifies their income portfolio. You mentioned the buy-write index. Do any advisors actually hold you to that? Do they look at that? Do they compare you to the S&P? Do they compare you to a 64-year-old? What is the bogey for most advisors that are? Or is it, again, the income target is the thing they care about?
Yeah, no, I think they definitely compare us to the buy right index because that's pretty fair. I mean, that's the S&P 500 with index calls written against it. So it's an appropriate benchmark. But it's hard to say, you know, when we talk to advisors, we go, Hey, this doesn't perform like the S&P, right? You know, if the market goes up,
you know, 20% will likely, you know, our beta is at 75. So we'll likely, you know, be around 15. That's just kind of how it works. But if the market's down, like it was in 2022, 19%, we'll get that around. We'll reduce the downward movement by about 10%. So we just, it's about education.
Um, and then them telling their clients, you know, how this performs and how it should. Obviously if we're in a sideways choppy market, this did you really well, um, because those calls aren't being called away, right? So you're selling those calls and you're just taking that premium and putting your pocket. So markets like that. And then, and it just, we underperform in the drastically up market, but it seems like, you know, we've had this before and we're just not seeing outflows. Like, so this year we're underperforming.
because the market's up well over 20% right now. But we're right there around 20%. But we're not seeing the outflows, but I think that has a lot to do with education and how the advisors know this is how it works in certain markets.
So you've been running this strategy for a long time. I'm curious. And what environment do advisors and their clients get upset? Because to your point, it's a bull market. Everybody knows that this is a strategy that is not going to keep up in a bull market, especially one that's the sort of environment that we're in. So I would assume that they're understandable in this type of market. But what is the market that says where they say to you, hey, this isn't doing what I think it's supposed to be doing? Yeah. So I think
Was it 2017 when the VIX was like at nine? That was tough. That's going to be impossible, right? Yeah. Yeah. So right now, uh, with the VIX is in the teens, that's, that's kind of a Goldilocks scenario for us. We're able to get some appreciation of online equities while hitting our cashflow target. When the VIX is at single digits, like it was during the zero and straight environment and the markets is kind of chugging up. Um, it was hard to do our strategy. Granted, we had the underlying equities that were going up, but we, we were,
I would say drastically underformed, but it was to a point where I had to write tighter, I had to write closer to the money, those type of things. So the upside was limited. Again, we have that balancing act because I like total return. I'm a portfolio manager. It's very important. And so I had that balancing act for getting some upside as much as possible while still hitting the cash flow target.
But so markets like that now, I think that was the toughest. That education piece is interesting to me because Michael and I have talked to other managers that manage alternative strategies. And a lot of times the strategy can be great in terms of the numbers or the sharp ratio, however we want to look at it. But if it's really difficult to explain to advisors or for advisors to explain to their clients, they're going to jump ship. Do you think that?
is a symptom of your strategy being relatively easy to explain and set expectations. Or do you think that the education piece has gotten way better over time and people are just advisors are better at that? Because to your point about people blowing out during a bad year, that's the biggest nightmare fraud of portfolio managers, right? It's like, listen, we're doing what we said we were going to do and you're punishing us for it. But now it seems like that doesn't happen as much anymore. Yeah. And it goes to the point like,
I've been doing this for so long. I think that's one of the big keys. But in saying that, we've had a lot of education just from like
You know, the TD Ameritrade Schwab Fidelity world where they're doing advertising left and right on options. Obviously with the mean craze or options, you have options liquidity going through the roof. Cost of options have dropped dramatically. So I think the public has gotten used to or more secure with the use of options. Obviously we're doing covered calls, which is a very conservative approach to options. So I think that's beneficial.
And it just become more popular and just people are more comfortable with it. So I think that's been one of the main reasons why we're up to, I don't know, 120 billion in this category for Morningstar.
You mentioned earlier that your portfolio could have frequent turnover. What does the stock selection look like? Yeah. So the stock selection is what we're doing is, again, we have asymmetric returns. So my upside is capped. I have a downside risk. So we're a well-diversified portfolio. Largest holding is Nvidia. We're running around 3%. And it's similar weighted to the S&P.
And so we're not making any individual name bets or sector bets because our upside's capped, right? So if it goes to like, if I'm overweight of financials and my financials do really well, they won't do as well because I'm writing the covered calls, but they don't do well. I love out underperformance in that sector because I'm overweight of that. So we're pretty, really careful about that.
Again, when we're looking at stocks, we look at the defensive quality, their market leaders, and they generate free cash flow.
It's a well-diversified portfolio. It's sector neutral. And where we really add value, I believe, is selling the cover calls and really generate those additional cash flow returns over the period that we sell the calls. Do you have to have any cell discipline then or are the getting called away? Is that your cell discipline?
So the sell deficit discipline is when the stock actually drops out of our, we have a four quartile process where we have a top quartile, second, third, fourth. When it drops out of the top quartile and it's getting called away, then we'll replace it with the stock that went into that top quartile. But you also sell even if it doesn't get called away if the stock is underperforming or whatever doesn't meet your criteria anymore.
Yeah, we definitely could. Typically, we have that flexibility with the options where we can sell options that are in the money. Let's say we're moving out of a position, so we'll start selling options that are tighter or in the money and let it get called away. But if something dramatic happens to the stock, we'll straight sell it, exactly.
Barry, the way that investors access your strategy right now is through a mutual fund. Yeah. So we have a mutual fund symbols, EQ, TIX. It's pretty much available everywhere. I would assume. Obviously you can contact your advisor and they can look it up as well. And then we have separately managed accounts that do a portfolio that's similar to this. It's not a mirrored portfolio because of the options, but it's very similar.
What about an ETF? That's where a lot of the flows into the strategy have gone. Does it not lend itself to what you do because you're too active and discretionary? How does that work?
No, I mean, I think down the road that's something that we might be involved in. But one of the detractors of the mutual fund versus the ETF is mutual funds typically have large embedded gains in the portfolio. So people are a little nervous about that. We typically don't have that. And so most of our gains are paid out on a quarterly basis. And the reason for that is that if we have dramatic appreciation of the stock,
It will get called away. So we don't have these stocks that we've owned forever in the portfolio that have large, large gains typically. So you won't see that in our portfolio. So I think this works really well in a mutual fund. It also works well in an ETF. Do investors in this kind of strategy care at all about interest rates? If the 10-year went to 5% or 6%, do people lose interest in a covered-call strategy or are the rates so high that it doesn't really matter?
If you're looking at option writing in a vacuum and you go back to your days of studying the Black Scholes model in school, interest rates is a big factor of option pricing, but the biggest factor is volatility. But when interest rates rise, you actually receive more for calls and puts.
So, in a rising interest rate environment, it's actually pretty beneficial for the option pricing if you're looking at it in a vacuum. If you're looking at underlying equities, obviously interest rates have a different effect on the underlying equities. But in general, a rising interest rate environment
Then you look at historical performance covered option writing has done very well. So it's been great for that. So, but we'll see like in a, in a dropping market, if you're looking at option pricing in a, in a vacuum, when it's rates go down, when volatility goes down, then you receive less for, for selling the calls and posts.
for advisors and clients that want to learn more about how they find your strategy. Where do we send them? Yeah, you can send them to the SheltonCap.com. Shelton Capital is your base in Denver, Colorado, has roughly about $6 billion in management. You know, we're not too big, but we're not too small. So if you call us, you'll get a live person on the line and they can, you know, you can talk to me. If you need to, if you need being, you have any questions going forward. I appreciate the time, Barry. Thank you. Really appreciate it. Thanks, guys.
Okay, thank you again to Barry. Great guest, SheldonCap.com, to learn more, email us animal spirits at the compoundnews.com.
