San Francisco's Shelton Capital Management wants to expand its options expertise to ETF advisors
“Try the Black & Blue,” Dennis Clark tells me at our first meeting. He points to a salad on the menu: a mix of organic greens, blue cheese and steak tips. It sounds delicious.
We’re sitting in The Royal Exchange, a staple of San Francisco’s financial district, discussing how Clark’s firm, Shelton Capital Management, is marketing its ETF-driven covered-calls strategy, and I’m not paying enough attention to the menu. When the server arrives, I blindly go with Clark’s advice. And like his firm’s clients, I’m not disappointed.
Nor does Clark let me down on discussing the San Francisco firm’s expansion plans to offer financial advisors solid model portfolios to ease the burden and allow the advisor to focus on the clients’ needs. Clark and his Shelton colleagues think they’ve found the perfect value-add: covered calls, run by portfolio manager Barry Martin.
LOOKING FOR THE NEXT STEP
Shelton’s clients have benefited from similar advice on the financial markets since 1985, when Dick Shelton started managing investments for friends and family. “Around 1993, it was Dick’s assessment that indexing was a great way to get equity exposure,” said Clark. “In hindsight, he turned out to be quite right.”
The majority of the firm’s $900 million in assets under management comes from the legacy Dick Shelton started—sound financial advice delivered wrapped in simplicity. Starting with advice on stocks and bonds, the advisory firm grew into a rapidly expanding mutual fund business, offering clients 13 diversified products. Mutual funds have provided a tremendous boon for the firm—Shelton’s flagship fund, the Shelton Core Value Fund, has more than $170 million in AUM—but the firm sought to look for new opportunities.
That’s when Dennis Clark, Shelton’s managing director, entered the picture. Clark joined Shelton two years ago, after speaking with the firm’s current CEO, Steve Rogers, about aggressive growth strategies for the firm. Clark felt there were other areas of growth out there; specifically, helping advisors.
“Advisors are looking for quality investment management firms they can trust, and who will work closely with them,” Clark said. “Someone who will really look at their general business needs, whether it’s marketing ideas, growing their business, continuing education or the identification of unique solutions to their clients’ portfolio needs.”
The biggest need, he found, revolved around addressing income and volatility. Many advisory shops offer model ETF portfolios in separately managed accounts, but only a few use options-writing strategies to limit volatility, often because of resource constraints. Shelton, however, has run options strategies on more traditional separately managed accounts for years, focusing on adding income to a portfolio’s total return. Adding that strategy to an ETF portfolio was a no-brainer.
Barry Martin, CFA, is the portfolio manager for Shelton’s Optima Diversified ETF Strategy, and no stranger to selling covered calls. He’s been working in the options markets for more than 10 years, selling covered calls for Shelton strategies for the past five.
Martin talks me through the strategy with an ease that’s built up from the three years that the ETF portfolios have been running. The strategy includes three portfolios: one each for conservative, balanced and growth-based risk tolerances. Each portfolio holds roughly 12 ETFs across a diversified set of asset classes: from U.S. stocks and bonds to emerging markets exposure and even gold, with weights assigned based on a client’s acceptable-risk level. Martin takes a passive approach with regard to the ETF models used, but applies an active covered-call strategy seeking to generate a total return with less volatility.
Covered calls, or options to buy a security at some time in the future for a set price, are nothing new. Investors have sold covered calls to generate income on possible volatility on existing stock positions for decades to add the premium to a portfolio’s return. But as ETFs have become increasingly popular, the options markets available for them have been a tremendous boon for ETF investors as well. One reason is because of the volatility of single securities: A 50 cent call on a $25 stock offers a 2% premium, but if the stock falls 20% ($5), you’ve still lost $4.50 in the process. ETFs offer lower volatility. According to a study from the Chicago Board Options Exchange, selling options on the S&P 500 Index reduces volatility by about one-third.
That lower volatility is precisely what Shelton aims to capture in its Optima portfolios. “In theory, what we’re doing is generating additional cash returns by monetizing the volatility,” Martin said. To achieve this, the firm keeps a constant tab on the options markets for the chosen ETFs, and as you’d expect, the activity in those markets plays a large role in choosing one ETF over another. While lower fees and higher trading volume are important, Shelton cites options volume as an important metric after the more usual due diligence is conducted when evaluating ETF choices. That leads to plenty of familiar names in the Optima strategy, including:
- SPDR S&P 500 (SPY)
- iShares Russell 2000 (IWM)
- iShares MSCI Emerging Markets (EEM)
- iShares MSCI EAFE (EFA)
- iShares Dow Jones U.S. Real Estate (IYR)
- iShares Barclays 20+ Year Treasury Bond (TLT)
- iShares Core Total U.S. Bond Market (AGG)
- iShares Barclays TIPS Bond (TIP)
- United States Oil (USO)
- PowerShares DB Commodity Index Tracking (DBC)
- SPDR Gold Trust (GLD)
Martin sells monthly calls on each ETF where available (45-day calls on GLD, for example) and reinvests the premium from the options back into the strategy. For single-stock strategies, this would generate income. But as Martin explains, because Shelton wants to keep its exposure to these broad ETFs, it often uses the premium to buy back exposure on a fund. This helps the risk-adjusted return, and according to Clark, lowers the overall volatility in the portfolio by about one-third.
That’s helped the Optima ETF Strategy deliver positive returns. For example, in the three years ended Dec. 1, 2012, Shelton says the Balanced Portfolio gained an annualized return of 9.5%, with a standard deviation of 8.41. Shelton highlights the lowered volatility, while still capturing much of the upside.
Martin characterizes even the riskiest portfolios in the Optima strategy as “fairly conservative.” “The time-tested asset allocation strategy—modern portfolio theory—is still alive and well” he said. “It still makes a lot of sense. The thing that’s different here—and why advisors hire us to do it as opposed to doing it themselves—is that we take an active and tactical approach to writing the covered calls. That’s the secret sauce: finding those options that are most overpriced and selling them as we attempt to deliver a superior total return with lower volatility.” Martin shrugged as he explained the simplicity of the strategy. “In this strategy, that’s really all that’s happening.”
SETTING IT APART
The strategy may be simple to understand, but getting the word out to advisors is still a challenge. Even with a three-year track record on the ETF portfolio and a manager with more than 10 years of options-managing experience, Clark has had difficulty putting the strategy in front of advisors who want to focus on client relationships instead of trading options.
Part of the issue is the stigma around options trading. “Anything with the word ‘options’ in it sets off alarms,” Clark said. “A lot of advisors have been reticent to even bring up options with their clients for fear that the alarm bells will go off.” Clark also notes the perception from the advisor herself that options add complexity. “Advisors want to deliver this type of solution, but they don’t have the time and resources. They prefer to dedicate resources to finding and servicing clients instead, and that’s where we add tremendous value.” Shelton counters these fears through education on how options affect a portfolio’s return.
Another roadblock comes from big technology platform providers such as Envestnet, many of whom cannot yet support covered-call writing strategies. “Technology’s still a little bit behind,” Martin said. “A lot of platforms that advisors use don’t have access to options yet, even though ETFs and the options chains following them are getting bigger and bigger. At some point, we need the platforms to catch up.” To get around this, Shelton opens new accounts directly at the client’s custodian—sometimes not an ideal solution.
Both the platform issues and the stigma around options have made the sales process slow. To date, the Optima ETF Strategy has about $30 million in assets under management, far less than the mutual funds that Shelton offers. Clark hopes to see that change. The firm has recently lowered its minimum to $100,000, down from $500,000, and with its aggressive fee structure (as little as 0.50% for large accounts, with most accounts in the 1% range), the growth may well be on its way. “While it has had slow growth up to now,” he noted, “I fully expect it to become one of our fastest-growing strategies. This should be our fastest-growing, most-popular product.” Clark is so confident in the strategy that he’s invested in the product himself. “Barry manages my own portfolio in this strategy,” he said.
The big challenge, however, is the increased competition in the intermediary space. Programs like iShares Connect offer advisors hundreds of third-party managers.
Still, Clark remains confident that the firm’s approach, both in investment theory and in customer service, will put them ahead. “We’re focused on the independent advisor,” he said. “This is the type of product that helps them set themselves apart from their competition, and we want to build a relationship, not just a vendor agreement.”