Overview of Talk Your Book: Structured Notes in an ETF
This episode of Animal Spirits (hosts Michael Batnick and Ben Carlson) features Jeff Schwarty of Simplify ETFs explaining a family of “auto‑callable barrier income” ETFs — essentially structured notes packaged inside an ETF wrapper. The conversation covers how these funds generate high distribution yields by selling barrier options against equity indices or individual stocks, how they’re structured (laddered weekly expiries, non‑call periods, knock‑in/knock‑out mechanics), historical behavior in drawdowns, fees, tax/treatment differences versus other income products, and who the strategies may suit.
Key concepts
- Structured notes: OTC option/derivative contracts traditionally sold to investors by banks; Simplify packages many such contracts into an ETF.
- Auto‑callable barrier option: an option that (a) provides premium income to the seller, (b) has a barrier/knock‑in level (e.g., 30%), and (c) can be auto‑called (terminated early) after a non‑call period if the reference index is above its initial level.
- Laddering / weekly maturities: the ETF targets ~52 positions so one contract matures each week — smoother roll and regular potential income stacking.
- European knock‑in: only the option value at expiration matters for whether the barrier was breached (intraperiod losses are mark‑to‑market only).
- Long protective put: Simplify adds a low‑cost long put (~20% OTM) as additional catastrophe insurance (cost ~12 bps).
How the strategy works (plain language)
- Simplify buys short‑term Treasuries to collateralize the trades and sells barrier options to banks, collecting premiums.
- Income distributed equals Treasury yield + option premiums (not return‑of‑capital, according to Simplify).
- Non‑call period (typically ~3 months) prevents immediate auto‑exercise. After it expires, if the reference indices are above the initial level, the contract may be called and the ETF keeps the premium and can redeploy.
- If at expiration the worst‑performing reference index is below the barrier (e.g., 30% below initial), the ETF participates in the drawdown on that contract (full participation once barrier breached).
- Laddering means not all exposure is concentrated in a single contract; each week one contract matures/rolls.
Product variants, barriers and target yields
- SBAR (index‑based): 30% barrier; core product; target distribution ~10% (distributed ~12.9% during elevated vol).
- XV (index‑based): average barrier ~25%; target distribution ~15%.
- XXV (single‑stock based): uses ~14 individual stocks; barriers typically 40–50%; target distribution ~25%.
- Fee: ~0.75% (75 bps) for these strategies.
- Simplify AUM and market context: structured notes market ≈ $450B; Simplify mentioned ~12B AUM.
When it performs well (upside case)
- Best case: rising equities combined with elevated volatility. Many contracts get auto‑called (you keep premiums and stack income); option premiums are higher during elevated vol.
- Upside is effectively capped to the Treasury yield + option premium distributed; not intended for investors seeking uncapped equity upside.
Risks, downsides and edge cases
- Mark‑to‑market volatility: you may see large interim (unrealized) losses during rapid sell‑offs even if contracts ultimately don’t break barriers at expiration.
- Barrier breach: if the worst‑performing reference drops below the barrier at expiration, the ETF participates fully in that drawdown for that contract. Historical breach probability across their indices ≈ 7.8% (≈8%) over the last 35 years.
- Prolonged bear market risk: if a rolling 12‑month sequence repeatedly closes below the barrier at expirations, multiple contracts could be knocked in and produce losses.
- Not a fixed‑income substitute: returns driven by equity volatility and drawdowns; more akin to an alternative income or preferred‑like exposure.
- Tax treatment and distributions: Simplify says distributions are from option earnings (taxed at ordinary rates) — contrast with some high‑yield ETFs that use return of capital (which reduces cost basis but isn’t “earned” income).
- Upside capped: if you’re very bullish on equities, these funds will underperform a full equity allocation because upside is limited by the sold option structure.
Operational / structural benefits vs buying individual structured notes
- ETF wrapper provides:
- Continuous liquidity (can sell shares if you need cash — unlike multi‑year individual structured notes).
- No account minimums — easier access for retail investors.
- Removes operational friction for advisors (no need to monitor and roll dozens of OTC contracts manually).
- Centralized ISDA relationships and scale (Simplify negotiates contracts with counterparties on behalf of the fund).
Suitability and positioning
- Target investor: income‑oriented investors seeking high distributions and defined downside corridors who accept capped upside and derivative exposure; advisors who want outcomes of structured notes without operational complexity.
- Morningstar-like categorization: “derivative income” — not pure stocks or bonds.
- Advisors comfortable with structured products tend to adopt quickly; others may need study time due to derivative mechanics.
Performance and empirical notes (from the interview)
- Historical event example: COVID‑2020 sell‑off produced significant interim mark‑to‑market losses (simulation: ~‑27%), but many contracts later called during the rebound; end‑year impact on a particular contract could be less (simulation showed about ‑18% for an initial contract that did not breach the barrier).
- Since inception numbers cited (SBAR): realized ~10% vol, ~14% total return since launch period; distributions were elevated (~12.9%) during recent heightened volatility.
- Long put protection cost: ~12 bps.
Notable quotes
- “These are structured notes…we’ve put it together in an ETF in the form of a structured note of structured notes.” — Jeff Schwarty
- “We’re underwriting the risk that equities do not go down more than 30% over a one‑time period.” — Jeff Schwarty
- “This is not a fixed income substitute. It kind of feels like a preferred security.” — Jeff Schwarty
- Historical breach frequency: “92% of the time you don’t break the barrier…7.8% of the time you do.” — Jeff Schwarty
Action items / where to learn more
- Visit simplify.us for fund fact sheets, videos, and deep dives.
- Advisors: evaluate how a derivative income sleeve with a known barrier and laddered expiries fits client income objectives and risk tolerance; compare to covered‑call and buffer products.
- Investors: understand distinctions between earned distributions vs return of capital; model drawdown scenarios (short and prolonged bear markets) and tax implications.
Note: This summary simplifies complex derivatives mechanics for clarity. Investors should read fund prospectuses, fact sheets, and consult advisors/consult legal counsel before investing.