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Are Buy-Write Funds Good Buys?

This article first appeared in the May issue of Wealth Management Magazine and online at WealthManagement.com Equity markets stalled in 2015 after a relentless six-year rise from the depths of the Great Recession. Last year’s stagnant market, even with its bearish tilt, was a perfect set-up for buy-write plays. A buy-write is an option strategy featuring a stock purchase (that’s the “buy” part) along with the sale (a “write”) of a related option. Typically, these are call options. Deemed “covered calls,” they offset the otherwise unlimited liability associated with selling options through ownership of the underlying stock. The object of the strategy is income production. The premium earned for selling the options is retained if the contracts remain unexercised-a likely occurrence in a flat-to-bearish market. That’s not to say there’s no risk. If the market value of the stock spikes, pushing the options into the money, shares may be called away at the strike price, leaving the writer with just the premium and perhaps a bit more. What’s at risk is the upside potential of the stock, a sort of opportunity cost. Should the value of the underlying stock decline instead, the call premium provides a modicum of downside protection. A number of exchange traded funds engage exclusively in buy-writes. Most use call options. A couple, though, feature puts. Selling puts rewards investors in a stagnant or rising market if the underlying stock’s market price exceeds the put’s strike price; a downtrending market is anathema to this particular variation on the strategy. It’s worth a look at these ETFs to see how successful they’ve been in providing income and limiting risk. The PowerShares S&P 500 BuyWrite Portfolio (NYSEARCA: PBP ) writes at-the-money calls on its portfolio of S&P 500 securities. Launched in 2007, PBP is well established with $308 million in assets and an average daily volume of 109,000 shares. Over the past two years, PBP’s maximum drawdown was significantly less than the biggest hit taken by the SPDR S&P 500 ETF (NYSEARCA: SPY ) , a proxy for the blue chip index. Drawdowns represent peak-to-trough losses sustained before new price peaks are attained (see Table 1). Another metric of downside risk, Value at Risk (VaR), typifies the expected loss within a given timeframe. Essentially, VaR depicts a worst-case scenario. Based on the past two years’ returns and within a 95 percent confidence level, PBP can be expected to lose 1.12 percent on a bad day. Compared to SPY, with a daily VaR of 1.44 percent, PBP appears less risky than holding the index portfolio outright. A final comparative metric, M-squared (M 2 ), depicts the fund’s risk-adjusted return. Simply put, M-squared estimates what the fund would return if it took on the same level of risk as its SPY benchmark. PBP would have earned 3.82 percent-86 basis points more than its actual total return-if it was as volatile as SPY. If the M-squared return was lower than the fund’s actual return, the PBP portfolio would be more risky than the benchmark. So what about income? PBP boasts a dividend yield more than twice as high as SPY’s. Still, the buy-write fund’s total return is just a third of the level of the index fund-testimony to the effect of having assets called away as the market rose prior to leveling off. Click to enlarge Another ETF based on the S&P 500, the Horizons S&P 500 Covered Call ETF (NYSEARCA: HSPX ) , pursues a more aggressive call-writing strategy. HSPX sells out-of-the-money options, which, all else equal, typically produce less income. The fund, however, writes more calls than PBP-up to 100 percent of each stock position. This affords more equity upside. But there’s a trade-off for this-namely bigger drawdowns and a higher VaR compared to PBP. Despite the risk disparity, both funds earned the same M-squared return over the past two years. Chart 1 depicts the day-to-day performance of the buy-writes versus the SPY benchmark. Click to enlarge First Trust Advisors runs two actively managed buy-write portfolios, one geared to maximize income, the other designed to minimize volatility. The First Trust High Income ETF (NASDAQ: FTHI ) relies on a universe of large-cap stocks paying high dividends to underlie its call writing and rewards its investors with an attractive total return and dividend yield. The cost for this is higher risk, reflected in all three metrics: drawdown, VaR and M-squared. A sibling fund, the First Trust Low Beta ETF (NASDAQ: FTLB ) writes calls on the same portfolio as FTHI, but also buys put options to reduce volatility. The put premiums create a drag on performance, reducing both total return and dividend yield, but pay off with lower drawdowns and VaR compared to FTHI. Yet another actively managed portfolio, the AdvisorShares STAR Global Buy-Write ETF (NYSEARCA: VEGA ) , is even more expansive. A fund of funds, VEGA is presently made up of equity sector ETFs and bond ETFs in addition to broad-based ETFs like SPY and the iShares MSCI EAFE ETF (NYSEARCA: EFA ). The extensive call-writing base hasn’t produced capacious returns or dividend yields, though. A fund [1] that writes puts rather than calls is a standout, but not in a good way. The ALPS US Equity High Volatility Put Write ETF (NYSEARCA: HVPW ) selectively sells out-of-the-money puts on high-volatility large-cap stocks, aiming to maximize income. HVPW succeeds on that front. Its dividend yield is high, but volatility torpedoes the fund on a total return basis. HVPW, in fact, is the only ETF surveyed that produced a negative total return over the past two years. One other ETF requires special attention. Rather than being focused on the large-cap stocks populating the S&P 500, the Recon Capital NASDAQ 100 Covered Call ETF (NASDAQ: QYLD ) buys the stocks populating the Nasdaq-100 Index, a compendium of the largest nonfinancial issues listed on the Nasdaq marketplace. As you can see in Table 2 and Chart 2, QYLD shows the dramatic trade-off between total return and dividend yield. Compared to the PowerShares QQQ ETF (NASDAQ: QQQ ) , a portfolio that tracks the Nasdaq-100, QYLD produces a much bigger dividend yield, but a significantly lower total return. The risk metrics of the QYLD fund show the benefit derived from call writing. Click to enlarge Click to enlarge The Bottom Line Call-writing funds more often than not compensate for their relatively low returns with high dividends, making up for losses incurred over the past two years. Most of the funds, too, mute market volatility, providing higher risk-adjusted returns. Put writing, though, has been a vexation. The hefty premiums received for put sales just couldn’t cover the capital losses incurred as the options were assigned. Investors looking for high levels of current income and hedged exposure to the equity market might very well find call writing funds attractive alternatives in a flat-to-slightly bearish market. If, however, an investor or advisor believes stocks are poised for another sustained upward surge, less costly and mechanically simpler exposures are more suitable. [1] Another ETF, the ALPS Enhanced Put Write Strategy ETF (NYSEARCA: PUTX ) also pursues a put-write strategy, but was only launched in 2015, making it too young to include in our two-year study.

Floating Rate ETFs In Flux

This article originally appeared in the April issue of WealthManagement Magazine and online at Floating Rate ETFs in Flux . With fed rate hikes likely coming at a slower pace, investors flee some floating-rate notes. Nearly a year ago, as part of our survey of alternative income funds (” Alternative Alternative Income “), we picked through a number of floating-rate note (FRN) portfolios to find the potential best-of-class performance should interest rates rise. Well, since then rates have risen by 34 basis points in the three-month Libor and 26 basis points in the three-month T-bill yield. Curiosity compels us to revisit the floater funds to see how the asset class has fared. Not all these portfolios are alike, so one shouldn’t expect uniform results. The vast majority of the $9.8 billion held by exchange traded fund (ETF) versions are invested in corporate securities. And, among these, there’s further differentiation by credit ratings. Most investors are attracted to funds holding high-yield securities, though significant assets are committed to investment-grade paper. The junk/quality split is 54/40 with the remaining 6 percent in municipal and Treasury notes as well as a fund devoted to variable-rate preferred stock and hybrid securities. Money Flows Overall money has flowed out of the 12 ETFs plying the floater trade over the last 12 months. Net redemptions of $417 million reduced the category’s asset base by 4 percent. This wasn’t a wholesale dumping; it was more tactical. Some segments lost assets, some gained. And that’s a story in itself. Junk note funds lost nearly 16 percent, or $986 million, while ETFs invested in higher-grade corporate notes saw inflows of nearly 5 percent, or $183 million. At the same time, there was a $5 million, or 45 percent, boost in the newer (and smaller) Treasury segment. The single fund devoted to municipal notes bled assets, losing $27 million, or 28 percent, of its base while the other singleton, the variable preferred stock ETF, tripled in size with $408 million in net creations. Two trends are at work here. Some of the high-yield assets migrated to safer havens, namely bank-grade and Treasury paper. Mainly, that’s been an escape from duration risk. Money’s also being drawn to the equity side in response to more encouraging economic data. The second trend is a mercenary search for yield. Consider the inflow to the preferred stock ETF. Dividend yields for variable preferreds indexed in the Wells Fargo Hybrid and Preferred Securities Floating and Variable Rate Index exceed 5 percent, significantly higher than the rates earned by junk notes. Investors believe that stocks, common or preferred, are okay to buy again. Especially if they produce lip-smackin’ income. The insulation from duration risk is a boon. So, let’s take a closer look at the cash thrown off by these ETFs, along with their return characteristics. High-Yield Corporate Floaters The 600-lb. gorilla among high-yield floater ETFs is the $3.7 billion PowerShares Senior Loan Portfolio ETF (NYSEARCA: BKLN ) , which owns more than 70 percent of the segment. As BKLN goes, so goes the segment. Buoyed by a market-weighted 4.22 percent dividend yield, high-yield ETFs collectively earned a total return of -2.54 percent over the past 12 months. The segment’s discernible duration is 2.27 percent, making it the most rate-sensitive in the asset class. When benchmarked against the i Shares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ) , a broad market bond index tracker with a duration of 5.53 percent, you can see the bargain made by FRN investors: Aiming for higher dividends and less rate sensitivity, they settled for lower overall returns. Despite its middling dividend yield, assets have flowed to the First Trust Senior Loan ETF (NASDAQ: FTSL ) in the past year. FTSL is actively managed with a mandate that allows the portfolio to be invested in non-U.S. paper and equities. Net creations have boosted the fund’s asset base by 87 percent. Investment-Grade Corporate Floaters Dividends are a lot lower in the bank-grade segment. With a collective “A” credit rating, the segment’s market-weighted yield is just 0.58 percent. Modified duration, at 0.12 percent, is very low as well. Like high-yield corporates, total returns have been negative, though at -0.40 percent, less so. The $3.5 billion iShares Floating Rate Bond ETF (NYSEARCA: FLOT ) sets the segment’s pace, though the fund to beat has been the SPDR Barclays Investment Grade Floating Rate ETF (NYSEARCA: FLRN ) . FLRN is the only corporate floater that produced a positive total return over the past year. Treasury Floaters Floating-rate Treasury paper, with its low yield and virtually nonexistent duration is really a cash substitute. Investors, wary of potential Fed rate hikes, have goosed up the segment’s small asset base in the last 12 months. It’s the only segment, too, that’s produced a positive, albeit small, total return. Nearly all the segment’s assets are held in the iShares Treasury Floating Rate Bond ETF ( TFLO) . Other Floaters There are a couple of ETFs at the corners of the floating-rate market. The PowerShares Variable Rate Preferred Portfolio ETF (NYSEARCA: VRP ) , claiming the highest dividend yield in the class, earns the variable moniker in more than one way. It’s been one of the category’s more volatile issues, and ended up losing money overall in the past 12 months. A stablemate, the PowerShares VRDO Tax-Free Weekly Portfolio ETF (NYSEARCA: PVI ) , owns municipal bonds, rated AA- on average, that can be redeemed weekly. Duration is negligible, which make the fund a cash substitute. With no dividend stream, however, the total return pretty much reflects its holding costs. No wonder the fund lost assets. An Overview The side-by-side comparison in Chart 1 shows how the category’s biggest funds behaved over the past 12 months. Three ETFs-FLOT, PVI and TFLO-varied little from their starting values, but BKLN and VRP wobbled significantly. Such volatility speaks to inherent risk. Floating-rate funds limit duration risk so they’re obliged to take on more credit risk to generate attractive returns. We seem to have reached a risk inflection point, though. By and large, investors are fleeing the risk in the high-yield corporate market. That exodus, in great part, reflects investor perceptions that Fed rate hikes may be coming at a slower pace than originally expected. The advantage of holding variable-rate securities, then, has diminished, making other assets more appealing.

Low Volatility ETFs May Be 2016’s Best Bet

This article originally appeared in the February issue of Wealth Management and online at WealthMangement.com. Simple and straightforward is the way to go, particularly given the shaky start to the year. Ask market prognosticators about the recent market rout and prospects for 2016, you will hear a lot about volatility. A recent Barron’s Striking Price column warned investors that “stocks will do about as well in 2016 as they did in 2015, but with more frequent price swings,” citing central bank actions here and abroad, a shallower option market and lower corporate profit margins as contributors to more market oscillations in the year ahead. Société Générale strategist Larry McDonald pointed to weak oil prices when he advised investors to “get long volatility.” And, in a note to clients, Morgan Stanley stock strategist Adam Parker broadly exclaimed “we are likely headed for a choppy year of low returns, and suspect many others think the same.” Volatility isn’t good for stock returns. You can see its deleterious effect especially displayed in the wake of drawdowns. A drawdown is a peak-to-trough decline in an investment’s value. A stock that topples from $100 to $80 before starting to recover suffered a 20 percent drawdown. That’s bad news certainly, but what’s worse is this: It takes more than a 20 percent gain to get back to even. To reach $100, an $80 stock must, in fact, rise 25 percent. After a 30 percent drawdown, a 43 percent move is required to recover lost ground. And on it goes. Big drawdowns need even bigger recoveries. 2016 looks to be studded with drawdowns, making it a banner year for low-volatility plays. And that’s good news for manufacturers of certain exchange traded funds (ETFs). Large-Cap, Low Vol There are eight low-volatility ETFs benchmarked to the S&P 500, each trying to solve the drawdown problem in a distinct manner. If we compare these funds to an S&P 500 tracker such as the iShares Core S&P 500 ETF (NYSEARCA: IVV ), we can get a sense of their effectiveness along a number of risk parameters. First, there’s the maximum drawdown conceded in the past year. Seven of the low-vol funds countenanced smaller drawdowns than IVV’s 12 percent hit. The entire set of ETFs beat IVV on a Value-at-Risk ((VaR)) basis. VaR represents an ETF’s potential daily loss at a 99 percent confidence level. IVV can be expected to lose no more than 2.3 percent of its value on 99 days out of 100. On average, the low-vol portfolios show a 1.9 percent VaR. Another measure, M-squared (M 2 ), gauges the risk-adjusted return of each ETF. M-squared depicts the ETF’s return if it was as volatile as the IVV portfolio. The higher the M-squared value relative to an ETF’s total return, the better. On this basis, the S&P 500-benchmarked ETFs are a mixed bag. Collectively, they skew negative, but that’s due to the performance of one extreme outlier. Without that one fund, the seven remaining ETFs exhibit an average 0.2 percent volatility benefit. This brings us to returns. Only one of the low-vol products exceeded IVV’s gross performance last year. Six conceded upside as the cost of reduced volatility, and one was a double whammy of negative returns and deeper drawdowns. The Best and Worst Performers The best performer was the PowerShares S&P 500 Low Volatility Portfolio ETF (NYSEARCA: SPLV ), which tracks a weighted index of the 100 least-volatile stocks in the S&P 500. SPLV covers all four bases: a higher total return than IVV, a shallower maximum drawdown, less VaR and a significantly high M-squared value. Despite this, SPLV correlates highly to IVV with a .87 r-squared coefficient. Beta, at .90, is close to the benchmark ETF as well. The worst overall performance was turned in by the PowerShares S&P 500 Downside Hedged Portfolio ETF (NYSEARCA: PHDG ), an actively managed ETF built on S&P 500 component stocks overlaid with VIX (CBOE Volatility Index) futures. PHDG can, during periods of exceptional volatility, maintain a substantial cash position as well. Presently, the asset mix is 90 percent stocks and 10 percent VIX futures. Oddly enough, VIX futures are themselves notoriously volatile. And not in a good way. The annualized standard deviation in settlement prices for the January 2016 contract topped 51 percent over the past eight months alone, making it a very expensive exposure to maintain. That, and swaps into and out of cash, contributed to PHDG’s negative return. Also noteworthy is the Janus Velocity Tail Risk Hedged Large Cap ETF (NYSEARCA: TRSK ), a portfolio that allocates 85 percent of its heft to equity exposure and 15 percent to a volatility hedge. TRSK isn’t selective-it holds all the S&P 500 component stocks overlaid with a dynamic long/short exposure to short-dated VIX futures. The hedged portfolio aims for a 35 percent net long exposure. TRSK gets close to its target, too, earning a .31 beta coefficient over the past year. Still, TRSK trades return for low drawdown risk. Two other low-vol portfolios trade in the large-cap space, but are not benchmarked to the S&P 500. The SPDR Russell 1000 Low Volatility ETF (NYSEARCA: LGLV ) draws the least volatile stocks from the Russell 1000 universe on an unconstrained basis, while the stocks selected for the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) are chosen and weighted subject to sector and correlation limits. Even though the USMV portfolio is a derivative of a different index, it’s been more closely correlated to the iShares Russell 1000 ETF (NYSEARCA: IWB ) than LGLV over the past year. (The only domestically traded ETF tracking the MSCI USA Index is now equal-weighted. Accordingly, we used an ETF tracking the cap-weighted Russell 1000 as LGLV’s benchmark to better gauge the effectiveness of the embedded low-volatility strategy.) In the end, USMV comes out on top, producing significantly higher total returns and lessened downside risk compared to IWB. Don’t Forget Mid-Caps and Small-Caps The stock universe for the iShares Core S&P MidCap 400 ETF (NYSEARCA: IJH ) is the same trolled by the PowerShares S&P MidCap Low Volatility Portfolio (NYSEARCA: XMLV ). Currently, about 80 of the least volatile S&P MidCap 400 companies take up residence in XMLV. The fund ends up fairly well correlated (r-squared at .81, beta at .79) with IJH, but handily outdoes the index tracker in terms of total returns and risk. Three ETFs follow low-vol strategies in the small-cap space, one tied to the S&P SmallCap 600 Index and two bound to the Russell 2000. Like its SPLV and XMLV siblings, the PowerShares S&P SmallCap Low Volatility ETF (NYSEARCA: XSLV ) tracks a volatility-weighted index of stocks derived from its benchmark. About 120 of the least volatile securities in the S&P SmallCap 600 Index populate the XSLV portfolio, producing a .80 beta and a .84 r-squared value. Even so, the low-vol ETF’s one-year return was double that of the iShares Core S&P SmallCap 600 ETF (NYSEARCA: IJR ). The SPDR Russell 2000 Low Volatility ETF (NYSEARCA: SMLV ) comprises small-cap stocks selected and weighted by low volatility and other factors, yielding a portfolio modestly correlated to the iShares Russell 2000 ETF (NYSEARCA: IWM ). IWM’s movements explain about two-thirds of SMLV’s. The low-vol fund delivers a .70 beta and a .64 r-squared coefficient while nearly trebling IWM’s one-year return. Summing it all up You could say that the low-vol ETFs we’ve examined do what they promise-if VaR is your yardstick, that is. All 14 portfolios produced VaR values below that of their benchmark ETFs. In terms of maximum drawdowns, 13 ETFs-93 percent of those analyzed-experienced shallower slumps than their bogeys. But here’s the kicker: Only 36 percent-5 of 14-low-vol products outdid their associated index trackers’ total returns.The common denominator for these funds is simplicity. Most utilize a straightforward screen that filters stocks by standard deviation, with the least volatile issues given greater weight in the ETF portfolio. Overlays, equal risk weighting and other complex schemes can produce portfolios with low risk parameters, but they often do so at the cost of truncated returns. It’s no wonder really. Many of these low-vol strategies are products of sophisticated financial engineering. Complexity often engenders unintended or unwanted outcomes. Investors seeking low-risk returns in 2016 may want to heed the words of that great engineer Leonardo da Vinci who declared, “Simplicity is the ultimate sophistication.”