Investors Need to Know What Option-ETFs Can Do—and What They Can’t.

Investors Need to Know What Option-ETFs Can Do—and What They Can’t.

The exchange-traded fund industry is unlocking many investment opportunities that were previously available only to the more sophisticated investors.

Access to the options market is one of them. Option-based ETFs have grown increasingly popular this year, as investors seek alternative sources of income or protection from market downturns. But investors need to understand what the trade-offs are for such benefits.

Since 2019, fund companies have launched more than 120 ETFs that hold and trade options. Prior to that, only about 20 funds occupied that category, most of which were struggling to gain traction. “The type of investors who would want options exposure would normally do it themselves, rather than using ETFs,” says Ben Johnson, Morningstar’s director of global ETF research. “This allows for greater flexibility to create strategies that are customized to their specific needs.”

But investors’ interest in options ETFs has clearly increased in the past year. The group has raked in more than $8 billion in new cash this year, nearly doubling its total assets under management.

Most option ETFs aim to serve one of two purposes: income generation or downside protection. That could look particularly attractive with bond yields near historical lows and stocks hitting new highs. For example, the $4.2 billion

Global X Nasdaq 100 Covered Call

ETF (ticker: QYLD) generates steady income from selling call options on the Nasdaq 100 index—at the cost of potential gains. Because call buyers have the right to purchase underlying stocks at a predetermined price if the index rises above that threshold, the ETF needs to own those shares to “cover” the calls. And if the index climbs a lot, the fund has to sell the stocks at lower prices and forego the gains.

That’s what happened this year: Although the Nasdaq 100 is up by more than 21% in 2021, the Global X ETF has returned only 9%, including the reinvested income from selling call options. Nonetheless, despite the smaller gains, investors have poured more than $2 billion into the fund this year, anticipating less room for stocks to rise in the future.

Global X offers similar strategies for the S&P 500 and Russell 2000, but those products aren’t nearly as popular as the Nasdaq 100 Covered Call ETF. The Nasdaq 100’s concentration on technology and growth stocks means that it’s trading at much higher valuations, says Global X research analyst Rohan Reddy. The index is also historically more volatile, which means higher premiums received on writing calls.

The $647 million

Amplify CWP Enhanced Dividend Income

ETF (DIVO) takes a more active approach, aiming to provide high yield from both dividends and covered calls. Its managers pick about 30 blue-chip stocks with attractive dividend yields, and then write covered calls on some of them from time to time—often on those expected to see little price appreciation—to pick up extra income.

ETF / Ticker Expense Ratio AUM (mil) YTD Return Actively Managed?
Global X Nasdaq 100 Covered Call / QYLD 0.60% $4,243 9.1% No
Amplify CWP Enhanced Dividend Income / DIVO 0.55 646 15.9 Yes
Simplify U.S. Equity PLUS Downside Convexity / SPD 0.28 284 19.5 Yes
Innovator S&P 500 Power Buffer August / PAUG 0.79 183 4.9 No

Note: Data through Sept. 1

Source: Morningstar

The fund currently writes call options on five stocks:

Duke Energy

(DUK),

Dow

(DOW),

ConocoPhillips

(COP),

Apple

(APPL), and

Microsoft

(MSFT). It has returned 16% this year, with a 12-month yield of 5%. That’s much higher than many pure dividend funds. The fund has attracted more than $400 million in new assets in 2021, according to Amplify CEO Christian Magoon. Many advisors have been using the ETF to complement or replace dividend and high-quality funds in their portfolios, he tells Barron’s.

Other option-based ETFs are geared toward protecting investors from losses in a down market. To achieve that, they often use put options, which give shareholders the right to sell the underlying stocks at a predetermined level if the actual price falls below that threshold. That provides the funds with a floor under their losses. While that sounds great, the protection doesn’t come free. Buying puts costs money regardless of which direction the underlying assets take.

The buffer ETFs have figured out a way to cover that cost. These funds buy put options for protection while selling calls at the same time. Doing so, however, caps their gains if prices of the underlying assets move up a lot.

While buffer ETFs appear to be at odds with how markets generally perform—they tend to go up more than they go down—in today’s somewhat precarious market, some short-term protection could ease anxieties during bad periods.

Before jumping in, however, investors should understand a few things about these sophisticated products: the exact amount of loss that’s protected; the period that the protection covers; and the price of that protection. The $183 million

Innovator S&P 500 Power Buffer-August

(PAUG), for example, protects investors against the first 15% losses of the S&P 500 over one year starting from Aug. 1, 2021. But if the market is up during the period, the fund can gain no more than 8%. Investors will also need to pay a hefty management fee of 0.79%.

Buffer ETFs aren’t the only answer. The $283 million

Simplify U.S. Equity PLUS Downside Convexity

ETF (SPD) has most of its assets invested in the

iShares Core S&P 500

ETF (IVV), but overlays the portfolio with put options to mitigate losses during downturns. The steeper the selloff, the more the protection. The fund has no cap on the upside because it doesn’t write calls. But it does need to pay for the cost of buying puts—in this case, about 2% of its net assets.

An attractive aspect of the fund is that computer algorithms actively move money in and out of its option holdings and reinvest the gains immediately, says Simplify managing partner Harley Bassman. “This creates a compounding effect that is massively valuable,” he says. The fund charges a relatively low fee of 0.28%.

Other option-based ETFs can be even more complicated, using various puts and calls to boost upside gains, hedge downside risks, generate income, or try to do all of that.

Still, most investors are probably better off with simpler exchange-traded funds that have more straightforward goals.

Write to Evie Liu at evie.liu@barrons.com

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