Pegasus
At it's core, the Pegasus portfolio is a high yielding, lower beta portfolio that is continuously hedged by generating income. Though it varies based on clients risk level, a high percentage of the portfolio is invested in ETF's that are specifically designed to produce monthly distributable income, while still providing exposure to the equity market with less volatility. I'll refer to these ETF's frequently as HYLBE (High Yield Low Beta ETF).
So what does lower Beta mean?
Let's put some numbers to it with Example1. Theoretically, if we had a $100,000 and split it between the Nasdaq 100 (QQQ ETF beta of 1.30) and the S&P 500 (SPY ETF beta of 1.00) we would have a portfolio with a beta of 1.15. If the market were to go up 10% in one year the portfolio would go up 11.5%, and produce $11,500 in capital appreciation. If we took the same $100,000 and invested it in the HYLBEs (combined beta of .80) we would go up 8%, and produce $8,000 in capital appreciation. A lower beta portfolio will move less the market.
What is the yield from the HYLBE's and how is it generated?
The HYLBE's generate a large portion of their yield by using an options overlay that sells weekly and/or monthly out of the money calls in either the SPY or the QQQ. So the yield comes from the individual stocks that the ETF owns and the premium from selling calls. It is important to note that the premium will vary with changes in volatility. Typically, when equity markets go down, volatility rises and call premiums go up, the reverse happens in rising equity markets. Suffice to say, changes in volatility will greatly effect the yield of the these ETFs! Over the course of 2022, the month to month yield has been between 7.6%-14.0% on an annualized basis.
Now lets add in the dividends that these assets produce in Example1. The dividend yields below were on August 27th, 2022.
The portfolio invested in the SPY (dividend yield of 1.69%) and QQQ (dividend yield of .61%) would yield 1.15% or an additional $1,150 for a total return of $12,650.
The HYLBEs (one currently yielding 9% and the other 10%) would yield 9.5% today, but in this example it would be more correct to use their historic yield in less volatile times, of 7%. This would add an additional $7,000 for a total return of $15,000.
In Example2, same portfolios as above, and the market goes down 10%
SPY and QQQ portfolio produce a capital loss of $11,500, but some of this loss is offset by the dividends earned over the year. Dividends provide a portfolio with "income support", regardless if the market is up or down. If we assume the same yield from the previous example of 1.15% that would add $1,150 for a total loss of $10,350.
The HYLBE portfolio (.80 beta) would produce a capital loss of $8,000. This loss is offset by the dividends earned over the year and applying a yield of 8.0%, would add $8,000 for a total gain/loss of $-0-. You may have noticed the yield in the HYLBE portfolio is 8% in this Example2 and was 7% in the Example1. The difference in yield is based on the assumption that the options overlay will have an increase in its premium in higher volatility markets.
Example3, same portfolios, market down 30%.
SPY and QQQ portfolio produce a capital loss of $34,500. Adding the same dividend yield of 1.15% that would contribute $1,150 for a total loss of $33,350 at year end.
The HYLBE portfolio (.80 beta) would produce a capital loss of $24,000. Adding the current dividend of 9.5% that would contribute $9,500 for a total loss of $14,500 at year end.
What would the market return need to be for these two portfolios to recover from this down 30% year?
The SPY/QQQ Portfolio would need a market return of @40.8%
The Pegasus Portfolio would need a market return of @11.2%
Looking at the difference in losses, and the ability to recoup them, it starts to become clear that the HYLBE's are in themselves a hedge in a down market. Their lower beta and large dividend, relative to the market, make HYLBE's a cornerstone for any portfolio.
Example3 provides a great segue to how we reinvest the dividends the portfolio earns. The HYLBEs distribute their dividends monthly. The Ex Dividend date is normally around the 1st and the Pay Date follows by a few business days. Some clients will want to keep the dividend as income, but most investors will want to reinvest them back into the market. Typically this would consist of reinvesting into the same HYLBE that provided the dividend. An exception to this reinvestment strategy presents itself in a bear market, which is a market down 20% or more. Some clients may want to increase the beta of their portfolio by reinvesting the dividends into higher beta ETFs like SPY, QQQ, and IWM (small cap ETF). Why? The 3 year return in the S&P 500 coming out of a bear market is an average of 100%. The average bear market duration is 17.5 months so we could potentially increase the portfolio beta by .5 during this time. The average maximum drawdown in a bear market is @ 40%. We are not attempting to call a market bottom with this strategy, we are simply leaning into more beta as the market gets less expensive. The trigger point to add more beta will vary from client to client based on their risk profile. Some may want to start adding beta with a 10 percent market decline, others might want a 30 percent decline or more. If and when the bear market ends, the portfolio can be rebalanced back to it's target beta. Again, the trigger point for this rebalancing is set by the client, based on their risk tolerance.
What About Bonds?
The example portfolios above have no bonds in them. Of course many investors have a "diversified" portfolio which includes bonds as well as equities. It would be deficient to not compare the Pegasus portfolio to a bond/equity portfolio.
Bonds in a portfolio can reduce volatility and provide income. Calculating the beta of a bond/equity portfolio is a bit tricky because we have to make assumptions about the value of bonds in different market conditions. Bond values could increase in "flight to safety" to fixed income assets, or a lowering of interest rates by the Federal Reserve. Bond values could decline with credit risks, lack of liquidity, or the Federal Reserve raising interest rates. Therefore in the following examples, we will assume a fixed value for the bond fund.
The Pegasus portfolio in our examples has a beta of .80. Let's compare it to a hypothetical portfolio of 80% SPY (beta of 1) and 20% allocated to a Total Bond ETF (avg. effective yield is 8.9 years, average coupon 2.6%). $80,000 in SPY, $20,000 in bonds.
Market advances 10% in one year.
SPY would produce a gain of $8,000, and the dividend would contribute $1,352. Bonds would distribute $520 in dividends for a total gain of $9,872. Do you remember how the HYLBE Portfolio fared? Capital gains and dividends totaled $15,000.
Market declines 10% in one year.
SPY would produce a capital loss of $8000, and the dividend would contribute $1,352. Bonds would distribute $520 in dividends for a total loss of $6,128. Pegasus? Gain/loss $0.
Clients that want more equity exposure (more beta) and taxable accounts can and should have a percentage of their assets in other high quality ETF's (SPY, QQQ, VOO, VGT, IWM, etc.). Clients that want less volatility can add bonds and/or use the direct hedging offered in Pegasus1 and Pegasus2 Portfolios.
The above examples are simple and theoretical, and use a snapshot of historical beta and yields, these factors are actually dynamic and change continuously. Obviously yields will change with a change in price of the underlying ETF. As the price of the ETF declines, the yield will go up if the dollar amount of the dividend remains the same. Also worth noting is the fact that the dividend is earned over the entire year, so the portfolios losses would be larger than the year end figure, until all of the years dividend is received. Also, these examples are free of taxes (IRA), trading costs, fees, etc.
Investing involves risk and you may lose money. Positive returns cannot be guaranteed. Historical betas of stocks and ETFs have no guarantee of actual, or future beta. HYLBEs use options to derive a large portion of their distribution. Options have unique risks, and all investors need to be aware of the unique risk of using options. The HYLBEs have counterparty risks with their use of Exchange linked notes (ELN). The counter party involved could default and cause unforeseen losses to the ETFs. The examples above are for educational purposes and are not a recommendation to buy or sell, any particular security.