Volatility Brings Buy-Write ETFs Into Focus
Summary Buy-write ETFs hold long equity positions while simultaneously writing covered call options hoping that the calls expire worthless so they can bank the options premiums. These funds tend to outperform in volatile or bear markets while underperforming in rising markets. Market volatility as measured by the CBOE’s Volatility Index has been on the rise since the 4th quarter of 2014. Market volatility as measured by the CBOE’s Volatility Index (VIX) has been on the rise thus far in 2015. Over the past couple of years, volatility has remained relatively tame as the market was marching upward in almost a straight line. In the 4th quarter of 2014, up until now, volatility has increased with much more movement on a regular basis. This comes right around the time of falling oil prices, weakness in several Eurozone countries, and high political tensions. Investors looking to maintain exposure to the equity markets, but also looking to protect themselves on the downside, might find solace in buy-write ETFs. These are the products that buy equity shares while at the same time write covered calls on those positions in an attempt to boost income and total return. These funds tend to underperform in rising markets as calls tend to get exercised limiting the overall upside potential. But they tend to do better in sideways or down markets as managers can let out-of-the-money calls expire and collect the premiums. One of the benefits of these products is that they tend to produce oversized yields. The Recon Capital NASDAQ 100 Covered Call ETF (NASDAQ: QYLD ) – an ETF that has been executing the buy-write strategy for over a year – has a current yield of 11.6%. It’s precisely that type of yield that helps cushion investors on the downside should the market turn bearish or become overly volatile. As expected, however, the ETF has underperformed the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and the PowerShares QQQ Trust ETF (NASDAQ: QQQ ) by a wide margin in 2014. The Covered Call ETF lost about 5% on the year compared to the NASDAQ 100’s 18% total return as the option premium income wasn’t able to overcome the upside limitation resulting from the exercised options. In a volatile or bear market though (which this ETF hasn’t experienced yet), we should reasonably expect that this fund could outperform the S&P 500 and NASDAQ as many call options would instead expire worthless. The Recon Capital ETF is just one such option in this space. Horizons S&P 500 Covered Call ETF (NYSEARCA: HSPX ) Whereas the Recon Capital ETF targets NASDAQ 100 stocks, this one focuses on the S&P 500 stocks. This fund, which launched in June of 2013, was able to grind to a 4% gain in 2014, and currently yields a little over 5%. Madison Covered Call & Equity Strategy Fund (NYSE: MCN ) This is actually a closed-end fund and targets mid- and large-cap companies across all exchanges and indices. It carries a current yield of 8.6% and has carried the same $0.18/share quarterly distribution since 2009. One thing to consider with this closed-end fund is that the distribution is in most cases not a pure dividend yield. Distributions on these funds are often times a combination of dividends, capital gains and return of capital. Taking a look at the fund’s most recent annual report , we can see that 22% of the 2013 distribution was a return of capital. In 2012, it was almost 98%. In other words, do your research to see what those yields are actually comprised of. Conclusion There are other buy-write funds out there, but these three cover some of the most popular strategies and products. These types of funds can be an important part of a larger portfolio so long as investors know the structure of these types of products. At roughly 60 basis points, the expense ratio on these funds is not excessive. Investors hoping for a market return in addition to an income boost will likely be disappointed though. We’ve already seen in the examples above that these funds will lag in up markets. In down markets, the funds could outperform, but that yield boost could come in a straight return of shareholder capital. These funds could be appropriate for a short-term play on a down market, but it’s unlikely you’ll want to hold them for the long term. But given the recent volatility the markets have already experienced lately, coupled with an uncertain global economic environment, these funds could find themselves outperforming in the near future. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.