Getting Funky With Factors

I believe I've gravitated toward using broad based equity funds to dial up equity beta like maybe after some sort of panic or short term freakout in the market or when I thought it was really time to re-equitize. I did this in mid-June, adding a small position where appropriate in a broad based equity fund, held it for a short time and sold it after a lift in the broad market. When these things work, you didn't buy enough and when they don't, you bought too much. The one in June was lucky. 

Depending on the circumstance, I could simply add a broad based equity fund, swap out of a diversifier (something that should go up when stocks drop) into a broad based equity fund or just sell a diversifier with no other action. Any of those would increase the net equity exposure of the portfolio in varying degrees and leave the rest of the portfolio in tact. 

If some broad based equity fund is what we're talking about, then I think it makes sense to explore factor funds. Examples of factor funds can include things like momentum, low volatility, even value/growth can be a factor. I've been calling the ETFs that buy at the close and sell at the open a factor fund. They are trying to capitalize on what they call the nighttime anomaly but I think of it as a factor. I'm test driving the large cap version of the strategy in one of my accounts, at this point there's nothing really wrong with it but I have no idea if I'll ever use it for clients.

A crucial point of understanding with any factor is that there are risks to the factor and periods where it will lag. If you can't figure out the risks for a factor funds you're interested in, I'd tell you not to buy it until you can figure them out. Growth and momentum, for example, will probably lag in a serious downtrend as has been the case this year. If you're going to consider some sort of factor fund you should probably spend some time trying to figure out when it is likely to struggle and also be prepared to stick with that factor for a while. The cycle of moving from one factor that has disappointed to the one that has been hot recently is going to end badly.

That brings us to the Overlay Shares Large Cap Equity ETF (OVL) which was featured on ETF IQ on Bloomberg. I'd never heard of the fund before Monday morning. It "seeks to outperform" with a "combination of capital appreciation and income generation." It does this by just owning an S&P 500 ETF and selling put spreads on the S&P 500. During the bear market, the fund is doing a little worse than the S&P 500. 

The put spreads look like they might be close to the money which increases the risk of being assigned of the S&P 500 goes down as opposed to the put spreads expiring worthless which is what you want to happen when you sell options or combinations that net out as a sale. The underlying options are European settlement, so no early assignment but if they are in the money at expiration then they settle for cash and in a declining market, that is likely to happen with selling puts that are close to the market resulting in a loss. They can close out the puts before expiration but that too would result in a loss. In the interview the fund manager mentioned that they limit the losses on the put trades to 3% which appears to the be difference in strike prices for each spread.

If you don't understand the preceding paragraph then I would not consider this fund until you did. 

Here's the YTD chart versus the S&P 500.

 

The correlation is close but clearly lagging this year. The manager said on ETF IQ that it is not a bear market strategy. Here it is though, from its inception up to year end 2021.

 

As opposed to being a little behind like it was in 2022, it's a little ahead most of the time while still looking very much like the S&P 500. The difference comes from selling the put spreads, that does generate income that is paid out to fund holders. Right now the yield is better than 4%. A proxy for the S&P 500 that yields quite a bit more than the S&P 500 will appeal to some people, at least on it's face. 

Selling put spreads close to the money is both risky and ergodic at the same time. The stock market goes up most of the time so put spreads don't get in the way of that ergodicity the way selling calls or call spreads would. Selling puts in a declining market is risky, especially puts that are close to the money. Client/personal holding Princeton Premium Fund (PPFIX/PPFAX) sells puts that are very far out of the money on a weekly basis so it takes on far less risk than OVL. Princeton is essentially a horizontal line type of alt where as OVL seems to outperform to the upside and go down more in down markets but of course who knows if that will continue to be the case going forward.  

I would add that OVL seems to go down the capitally efficient road combining an exposure to plain vanilla equities and volatility, volatility can be an asset class which is how I think OVL is using it. There is also leverage involved. Although the fund can sell put spreads equal to the notional value of the equity exposure, the fund is not levered 2 to 1 because of the narrowness of the spread trades. The fund is not leveraging down as we've described it before because both long equities and selling put spreads are bullish strategies, the spreads are not bearish anyway, but the extent to which it is leveraging up is quite small. 

If the spread exposure can consistently only put 3% at risk then I don't think the fund will really deliver much in the way of capital efficiency to an entire portfolio unless it was a core position. Compare that to the WisdomTree Efficient Gold Plus Equity Strategy Fund (GDE). The way that fund is structured, a small allocation could give a portfolio all the gold the typical, non-gold bug would want. 

OVL is interesting, so I will watch it. To be clear though, I have no idea if I would ever use it for clients or own it personally. I say regularly here that I spend a lot of time digging into all sorts of funds because it interests me but only a tiny fraction ever make their way into client portfolios. Also for the record, I have no interest or intention of using GDE in client portfolios or my own.