AMA 9 – Covered Call ETFs, Currency Hedging, and Bond Misconceptions | Rational Reminder 379
Audio Brief
Show transcript
This episode explores the conflict between what the financial industry is incentivized to sell and what genuinely benefits investors, using products like covered call ETFs as a prime example.
There are three key takeaways from this conversation. First, be skeptical of financial products promising exaggerated benefits or exceptionally high yields, as these often conceal hidden costs or deliver lower expected total returns. Second, a globally diversified, market-cap weighted portfolio should be your neutral starting point, with any deviations from this requiring a strong, evidence-based rationale. Third, for most investors, a single all-in-one asset-allocation ETF offers a superior, simplified solution for diversification and rebalancing, understanding that even traditionally safe assets like bond funds can experience significant volatility.
The financial system is driven to create and market products that cater to investors' perceived demands and behavioral biases, such as the desire for high income. This can lead to an oversupply of products with exaggerated benefits and an undersupply of those with underappreciated, true value. Covered call ETFs illustrate this by offering seemingly attractive income but often at the cost of overall total return.
A market-capitalization weighted portfolio represents the collective wisdom of all market participants, making it the logical default strategy. Any alternative weighting scheme constitutes an active bet against the market's aggregate judgment. Start with the market portfolio and only diverge if you have an exceptionally good reason.
Low-cost, globally diversified, all-in-one asset-allocation ETFs are a true game-changer for do-it-yourself investors. They significantly simplify portfolio management, removing the need for complex, often less effective, product combinations. These ETFs provide broad exposure and automatic rebalancing in a single fund.
It is also crucial to understand the mechanics of different asset classes. An individual bond has a fixed maturity, whereas a bond ETF continuously buys and sells bonds to maintain a constant average duration, making it perpetually sensitive to interest rate changes. Even traditionally "safe" assets like bond funds can experience significant volatility, as seen in 2021 and 2022.
These insights highlight the importance of aligning investment choices with evidence-based principles and prioritizing simple, effective strategies over complex, often misleading, financial offerings.
Episode Overview
- The episode explores the conflict between what is profitable for the financial industry to sell and what is truly beneficial for investors, using covered call ETFs as a prime example.
- It delves into common investor questions, clarifying the key differences between individual bonds and bond ETFs and explaining why market-cap weighting should be the default portfolio strategy.
- The hosts answer listener questions on specific products like swap-based ETFs, the philosophy behind using leverage, and their strong endorsement of simple, all-in-one asset-allocation ETFs.
- Through personal reflections, the hosts discuss the most fulfilling and frustrating aspects of their careers, highlighting their mission to combat financial misinformation.
Key Concepts
- Industry Incentives vs. Investor Interests: The financial system is incentivized to create and market products that cater to investors' perceived demands and behavioral biases (e.g., a desire for high income), even if these products have hidden costs or lower expected returns.
- Individual Bonds vs. Bond ETFs: An individual bond has a fixed maturity date and its duration decreases over time, while a bond ETF maintains a constant average duration by continuously buying and selling bonds, making it perpetually sensitive to interest rate changes.
- Market-Cap Weighting as a Default: A market-capitalization weighted portfolio represents the collective wisdom of all market participants and should be the neutral starting point for investors. Any other weighting scheme is an active bet against the market.
- Product Suitability and Risk Tolerance: The appropriateness of a financial product, such as a swap-based ETF or using leverage, depends heavily on the individual investor's knowledge, risk tolerance, and specific circumstances. A strategy suitable for an informed individual may not be appropriate for a fiduciary to use with clients.
- The Power of Simple Solutions: Low-cost, globally diversified, all-in-one asset-allocation ETFs (like VEQT) are a "game-changer" for investors, simplifying portfolio management and removing the need for complex, often less effective, products.
Quotes
- At 2:06 - "Capitalists respond to the actual demands for their products, not the demands that would exist if people were perfectly rational and truly understood their own best interests... Since people's demands are driven by the benefits they perceive rather than the benefits they actually get, the financial system supplies too many products with exaggerated benefits and too few products with under-appreciated benefits." - Benjamin Felix reads a foundational quote from John Campbell that frames the entire introductory discussion.
- At 28:26 - "This idea that, you know, bonds provide low volatility and security was blown out of the water in 2021 and 2022." - Ben highlights how recent market events challenged long-held investor beliefs about the safety of bonds.
- At 31:16 - "Start with the market portfolio, that should be your starting point, and if you want to be different from that, you have to have a very, very good reason... You have to talk yourself out of the market portfolio." - Ben introduces Eugene Fama's principle that market-cap weighting is the most logical and defensible starting position for building a portfolio.
- At 1:00:55 - "I think a lot of people don't want to be helped... They're furious that I would dare to try and help them." - Ben Felix describes his biggest professional frustration: encountering individuals who are hostile to receiving evidence-based financial advice.
- At 1:06:45 - "I think they have fundamentally changed the options for do-it-yourself investors." - Dan Bortolotti praises asset allocation ETFs as a "game-changer" that has massively simplified portfolio construction for Canadian investors.
Takeaways
- Be skeptical of financial products that promise exaggerated benefits, like exceptionally high yields, as they often come with hidden costs or lower expected total returns.
- Use a globally diversified, market-cap weighted portfolio as your starting point; any deviation from this should be a deliberate, well-reasoned decision.
- For most investors, a single all-in-one asset-allocation ETF is a superior solution for achieving diversification and rebalancing compared to building a complex portfolio from multiple niche products.
- Understand that even "safe" assets like bond funds can experience significant volatility, and it is crucial to align your expectations with the mechanical realities of how these funds operate.
