Meet the Buy Side: Real Passive & Diversified Income Featuring Matthew Patterson from HANDLS Indexes

Alex Cho

Alex Cho

CEO l Research Director

[email protected]

We’re proud to introduce our next guest to the “meet the buyside” series. Matthew Patterson from HANDLS Indexes. Matthew Patterson is one of the co-founders of HANDLS indexes, which they have licensed to Strategy Shares to launch the Strategy Shares Nasdaq 7 HANDL Index ETF (NASDAQ: HNDL) in January 2018. Matthew along with his co-founder, David Cohen, launched HANDLS Indexes three years ago.

Before launching HANDLS Indexes, Matthew was head of investment strategy and general counsel at Accretive Asset Management (AAM), which created Bullet Shares Indexes, which have raised an aggregate $12B in ETF AUM and were later sold to Guggenheim Investments and are now sponsored by Invesco. Prior to this, Matthew served as Assistant General Counsel for Claymore Securities, which raised a total of $40B in AUM before being acquired by Guggenheim Investments.

Given Matt’s extensive track-record in the ETF industry, we wanted to share his insights on creating index products, and his latest efforts to, yet again, create new index products where investors can achieve long-term investment goals in a diversified manner.

Q&A Section with Alex Cho and Matthew Patterson from HANDLS Indexes

Alex Cho (CEO and Founder of Cho Research) – Matt, thank you for taking time out of your busy schedule to host this Q&A session, and so I wanted to start by asking, perhaps a bit of your origin story, and how you came-up with the idea of launching HANDLS indexes?

Matthew Patterson (Co-Founder of HANDLS Indexes) – Our approach focuses on identifying underserved areas of the investment marketplace and developing investment solutions that cater to the unmet needs of investment advisors and their clients.

The inspiration for HANDLS Indexes came from the changing demographics of retail investors. Specifically, the Baby Boomers represent the largest pool of investment assets among retail investors and roughly 10,000 of them will retire every day for the foreseeable future. What this means is that they are transitioning from the accumulation phase of their investment lives to the distribution phase. And because very few baby boomers have enough assets to live solely off the income provided by government bonds and savings accounts, they require investment solutions that provide a high level of income while permitting them to draw down their savings in an orderly fashion. We created HANDLS Indexes to cater to their needs, with the objective of providing a high, predictable income stream that could be expected to last throughout retirement.

Alex Cho (CEO and Founder of Cho Research) – So, when it pertains to the Nasdaq 7 HANDL Index, it seems like an income generating vehicle, and fairly conservatively managed, which is why investors might consider this product for their income needs in retirement.

Can you kind of walk us through the strategy, and how it achieves the 7% net distribution target, and perhaps, why this strategy might be more appropriate than perhaps other income seeking approaches like REITs or utilities?

Matthew Patterson (Co-Founder of HANDLS Indexes) – It’s no secret that in an era characterized by historically low interest rates investors are seeking investment opportunities that provide more income than government bonds or savings accounts offer. This has led to the creation of a variety of niche products that pay high distributions, including ETFs focused on REITS, utilities, MLPs, covered calls, high-yield bonds and other income-oriented categories. While we see a place for these categories in investment portfolios, we also recognize that they come with high levels of volatility and idiosyncratic risk, meaning that they can be susceptible to shocks that don’t impact other categories. Perhaps no category better exemplifies this than MLP ETFs, which have seen poor performance coupled with very high volatility for the better part of three years.

HANDLS Indexes are built upon the teachings of modern portfolio theory, which suggests that investors who wish to earn higher risk-adjusted returns are better served by employing well diversified portfolios, also sometimes referred to as high Sharpe-ratio portfolios. They can then use leverage to increase the level of risk they would like to take (and enhance their potential returns) or hold more cash to reduce their risk (and reduce their potential returns).

To provide a well-diversified solution, the NASDAQ 7 HANDL Index consists of two components, a core portfolio and a Dorsey Wright explore portfolio. Each of the portfolios represents 50% of the index. The core portfolio is a static 70/30 fixed income / equity allocation, with the fixed-income portion consisting of three low-cost U.S. aggregate bond ETFs and the equity portion consisting of low-cost large capitalization equity ETFs. The Dorsey Wright explore portfolio consists of an ETF from 12 different income-oriented categories, including growth & income, MLPs, preferred securities, REITS, covered calls, dividend equity, utilities, active fixed income, high-yield bonds, investment grade corporate bonds, mortgage-backed securities and Build America Bonds (also known as taxable municipal bonds). The Dorsey Wright explore portfolio is reweighted on a monthly basis using a proprietary algorithm that incorporates yield, momentum and volatility.

The result is an extremely well-diversified solution that also incorporates a tactical tilt built upon the time-tested research of Nasdaq Dorsey Wright.

Alex Cho (CEO and Founder of Cho Research) – Okay, and so the first index product you’ve launched is traded under the ticker (HNDL), which is referred to as Strategy Shares NASDAQ 7 HANDL Index ETF, and so when it pertains to that specific ETF product, you’re able to generate a monthly distribution, and so can you kind of work-out how that monthly distribution works, and why this might apply to passive income investors looking for perhaps a monthly pay-out as opposed to a quarterly?

Matthew Patterson (Co-Founder of HANDLS Indexes) – Retirees and other income-oriented investors are seeking solutions that provide predictable distributions. Moreover, most retirees have expenses that recur on a monthly, rather than quarterly, basis—whether they be mortgage or rent payments, utility bills or other routine expenses. To address these needs, the Strategy Shares NASDAQ 7 HANDL Index ETF pays a managed distribution equal to 1/12th of 7% of the ETF’s net asset value on a monthly basis. The objective is for the ETF to earn a total return sufficient to fund this distribution.

Relying on total return to support a managed distribution can be a tax efficient way for investors to generate regular cash flows. Because the underlying portfolio currently generates about 3% of taxable yield, less than half of the distribution is taxable and the remainder is treated as a return of capital, meaning it reduces the investor’s cost basis in the investment. Unlike with mutual funds, the tax efficiency of the underlying ETFs in the portfolio allows for capital growth without regular capital gains distributions.

Alex Cho (CEO and Founder of Cho Research) – That’s pretty awesome, and so when it pertains to the fund’s cumulative performance of 15.3% year to date, it seems to be outperforming. Could you kind of walk-us through some of that out-performance, and whether investors should continue to anticipate a 7% distribution event regardless of interim market conditions?

Matthew Patterson (Co-Founder of HANDLS Indexes) – 2019 has been a strong year across the board for financial markets. With a large allocation to the U.S. aggregate bond market, the NASDAQ 7 HANDL Index benefited from the U.S. bond market rally we’ve seen in 2019. On the equity side of the index, the index’s largest allocation is to the Invesco QQQ ETF, which tracks the NASDAQ-100 Index. While the entire U.S. equity market has performed very well in 2019, the NASDAQ-100 index has generated the best performance of the major U.S. stock market indexes, which further aided the performance of the NASDAQ 7 HANDL Index.

As far as the 7% distribution goes, there can be no guarantee that the index, and therefore the fund, will achieve a sufficient total return to support a 7% annual distribution. But it’s important to understand that the fund’s monthly distribution of 1/12th of 7% is based on its current net asset value. To the extent the fund fails to earn an annual total return of 7%, basing the distribution amount on the fund’s then-current net asset value would have the effect of reducing the amount of the distribution, which ensures that the distribution won’t deplete the assets of the fund over long periods of time. This is important for investors who want to make sure they don’t outlive their savings.

Alex Cho (CEO and Founder of Cho Research) – Okay, and so when reviewing the ETF fund’s materials, the HNDL uses some leverage, albeit a fairly modest amount of 23% of the total portfolio, can you kind of explain how the leverage improves returns without resulting in too much portfolio volatility?

Matthew Patterson (Co-Founder of HANDLS Indexes) – In developing the NASDAQ 7 HANDL Index, we conducted a great detail of historical research into which types of portfolios have historically had the highest probability of supporting a 7% annual distribution over a 20-year period, which is the length of the typical American retirement. To do this, we looked at historical data going back more than 40 years. While the stock market enjoyed strong returns over that period, it also saw some dramatic downturns, including Black Monday in 1987, the dot-com crash of 2000-2002 and the financial crisis of 2008-2009. To evaluate how various portfolios would have potentially performed in different markets, we conducted 10,000 Monte Carlo simulations using monthly return data for stocks and bonds for the period from January 1, 1987 through December 31, 2016. What we discovered is that a 70/30 fixed income / equity portfolio had the highest probability (98.9%) of supporting a 7% distribution over a 20-year period without running out of principal.

What’s interesting is that we found adding a modest amount of leverage (23%) had relatively little impact on the risk of a 70/30 fixed income / equity portfolio running out of principal while paying a 7% distribution over a 20-year period. In 98.6% of the simulations, it managed to pay the distribution for the full 20-year period. But the use of leverage had a significant positive impact on the ability of the portfolio to maintain its inflation-adjusted principal balance even after paying out a 7% distribution for 20 years, with the median leveraged portfolio successfully accomplishing this feat. In the most favorable simulations, the leveraged portfolio significantly outperformed the unleveraged portfolio.

It’s important to understand that these simulations were based on historical performance and that of course they are no guarantee of future performance. But our research nevertheless supports the thesis that investors seeking higher returns are better served adding leverage to a high-Sharpe ratio portfolio rather than taking on idiosyncratic risk with niche investment categories.

Alex Cho (CEO and Founder of Cho Research) – Alright, so let’s turn the conversation over to fees, typically, ETFs try to offer the lowest fees possible, and so when we reviewed the material relating to the HANDLS ETF, the net expense ratio is 1.2%.

Now, given the predictable income nature of the fund, it’s worth noting that the fees can be justified, but can you kind of explain the reasoning for the expense ratio being at the higher end of the range?

Matthew Patterson (Co-Founder of HANDLS Indexes) – When we look at alternatives in the marketplace for investors seeking leveraged income and high managed distributions, the most obvious alternatives are closed-end funds and other ETFs that invest in closed-end funds. These products typically have very high expense ratios, particularly in the case of ETFs of closed-end funds, whose expense ratios tend to be more than 200 basis points. Moreover, these products incorporate the premium / discount volatility associated with the closed-end fund pricing mechanism, which effectively adds an additional layer of volatility with no corresponding return associated with it. By removing that premium / discount volatility, we can offer a similar investment experience with significantly less volatility and at a much lower cost.

Investors could, of course, seek to create their own portfolios that seek to accomplish what the Strategy Shares NASDAQ 7 HANDL Index ETF does at a lower cost, but it involves a fair degree of effort. For starters, they would need a margin account with their broker to add a comparable amount of leverage, and such accounts tend to have high fees for smaller investors. Moreover, funding a managed distribution at the individual account level while maintaining a balanced portfolio involves a lot of trading, which both takes time and generates tax consequences that may be undesirable. An ETF that holds highly liquid ETFs can do this much more efficiently and can use the creation and redemption process to minimize tax consequences.

Alex Cho (CEO and Founder of Cho Research) – Okay, and so when it pertains to those other managed products within the ETF, just how diversified is the HANDLS fund? Including, the various other products, and those managed products owning a diverse portfolio, could we imagine hundreds of different assets inside the HANDLS fund, can you highlight the amount of diversification we’re dealing with here? 

Matthew Patterson (Co-Founder of HANDLS Indexes) – The NASDAQ 7 HANDL Index consists of 19 ETFs that collectively provide exposure to approximately 20,000 U.S. securities from just about every taxable income-producing category you can think of. It is a very well-diversified solution.

Alex Cho (CEO and Founder of Cho Research) – After grilling you for so long discussing your initial (HNDL) ETF, let’s turn the conversation over to something that’s a bit of a softball. And so, if I remember a conversation, we had a while ago referencing your next major ETF product, and if I recall correctly, it would be an even more conservative strategy.

So, could you discuss your next ETF product in the works, which I believe is going to be called the “Strategy Shares NASDAQ 5 HANDL Index ETF.” Basically, instead of the 7% distribution, the ETF will target a 5% distribution yield. Can you kind of highlight more of that product?

Matthew Patterson (Co-Founder of HANDLS Indexes) – We developed the NASDAQ 5 HANDL Index to offer a solution for investors seeking income who would prefer not to use leverage. In addition, while the index employs a core-and-satellite approach similar to that of the NASDAQ 7 HANDL Index, its explore portfolio removes four of the income-oriented categories that tend to carry higher expenses and weights them by yield rather than employing a Dorsey Wright algorithm. The result is an index that targets a lower managed distribution and carries lower underlying fund fees.

The NASDAQ 5 HANDL has been licensed to Ping An Insurance of China and they listed the Ping An NASDAQ 5 HANDL ETF on the Hong Kong Exchange in December 0f 2018. It’s the first ETF of ETFs in Hong Kong. Also, as you mentioned, the index has also been licensed in the U.S. by Strategy Shares, but that product currently remains in registration.

Alex Cho (CEO and Founder of Cho Research) – Okay, and so one final question, and it pertains to an investment hero you’ve admired or someone who has shaped the course of your career, who would that person be, and how has he impacted your career, and turned you into the person you are, today?

Matthew Patterson (Co-Founder of HANDLS Indexes) – As an index provider, Jack Bogle comes to mind as the individual most responsible for popularizing passive investing and making people view indexing from a different perspective. Before he came along, securities indexes were viewed as benchmarks that observers could use to evaluate how the market performed and active investors could use to evaluate their relative performance. By creating the first S&P 500 Index fund, he effectively invented passive investing on a macro scale. And while he never embraced ETFs to the same extent that Vanguard did after he retired from there, his development of passive investing had a massive impact on the growth of the ETF industry.

Alex Cho (CEO and Founder of Cho Research) – Awesome, Mr. Bogle is certainly someone to admire. And, that also wraps-up our Q&A session today. I’m sure we will feature you again, Matt. Thank you for taking time out of your day to answer these questions and share your thoughts, and latest ETF product with our audience.

Matthew Patterson (Co-Founder of HANDLS Indexes) – Thank you for having me. It has been a pleasure.

***This concludes the Q&A section with Alex Cho and Matthew Patterson from HANDLS Indexes***

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