Exchange Traded...Income?

From Bloomberg, AQR alum Roni Israelov, now at NDVR, wrote a research paper that craps all over covered call funds. Two big takeaways are that the funds lose money over the long term on a price basis, so not including dividends. The other issue is more behavioral, he says it is a bad mistake to give up return (price appreciation) for income. He's quoted

“some investors might be attracted to covered calls for the wrong reason, seeking income rather than equity and volatility risk premia,” 

Ok, so lets take a look. First with total return.

 

Now just price.

In the same period, the Vanguard S&P 500 ETF had a CAGR of 11.59% including dividends with a standard deviation of 15.19. On a price basis then Israelov is not wrong. Almost ten years of data is a reasonable sample to look at. 

If you've been a regular reader for a while hopefully you know what I am going to say as a matter of consistency but going all in on something like covered call funds is a bad idea. A quick excerpt from a post a couple of weeks ago about retirement misconceptions. A commenter on a Yahoo article in italics and my reply if he'd have asked me in regular font.

I would much rather withdraw 10% or more per year from my retirement accounts and do it without taking any principal. How? I invest in buy-write ETFs that pay 11% or more per year in dividends, which pay monthly (so about 1% per month). 

Covered call funds have many favorable attributes. Keeping up with the broad stock market is not one of them. Assuming an 11% payout in perpetuity is a very bad idea. Part of the math that determines options premiums is the risk free rate of return from T-bills. T-bills now yield 5% after years of not having any yield. Building a plan based on assuming an 11% payout forever is really going to hurt this guy if that is what he is saying. Allocating a little to one of these, sure but going whole hog into anything is very risky and I don't think he has any clue of the risk he is framing out for himself. 

Just because all in is a bad idea doesn't mean a little exposure must be bad however. Something is said to be hormetic when a little exposure is good for your health but too much is bad for your health. Saying covered call funds are hormetic might be a stretch but you get the idea.

Back to Israelov's quote, they can be a way to add volatility as an asset class, in this case through something that sells that asset class, that sells volatility. They also do usually add quite a bit of yield. To the extent investors, like the blog excerpt above, take out all the yield and spend it, that is a bad idea in most instances although we have looked at a couple of exceptions where it isn't a bad idea. We've also looked at countless ways to incorporate a small allocation to covered calls funds to help reduce portfolio volatility, so using them as alts in a matter of speaking. I won't rehash that again in this post but you can play around with it on Portfoliovisualizer if you're curious, it's free.

Back to spending the entire dividend being a bad idea, we can circle back to a post from Thanksgiving where we cited a post from blogger Rida Morwa about not spending what he calls "extra yield." Four percent, maybe five, is a reliably sustainable withdrawal rate. Taking out 10% because that is the yield you're getting has a very high chance of failure which is crucial to understand. Morwa's idea was to take the 4-5% and reinvest the rest. Conceptually, that is sustainable. The portfolio needs to still be managed in decent fashion but it is not the obvious road to ruin that thinking 10% is sustainable would be. 

When I wrote about the Simplify Tail Risk Strategy ETF (CYA) possibly blowing up, I saw in the fund literature the expectation being set that the fund would drop in value and that holders should be prepared to buy more to maintain their position. The day I wrote about it, the fund closed at $0.83, today it closed at $0.53. 

The idea of buying more of these options funds that pay very high yields is interesting. I haven't mentioned it before but I am test driving a small position of the Defiance NASDAQ 100 Enhanced Options Income ETF (QQQY). Basically, the fund sells zero days to expiration (0dte) put options on the NASDAQ 100 Index. They believe the fund will look similar to covered call funds in terms of return profile. We'll see about that but it listed in September at $20. It closed today at $17.60. It has paid three dividends (the third one pays next week actually) totaling $3.03. On a price basis it is down 12% but on a total return it is up 2.15%. The new release declaring this month's dividend said it annualizes out to 60%. For now, the price isn't keeping up with the ex-dividend reductions (don't buy any of these kinds of funds without knowing what that means). I think there is a path where it could keep up better but that is not where we are now. I would also note that the monthly payouts for QQQY have crept down each month going from $1.10 to $1 to now $0.93. 

You can get a sense of some of the negatives of this idea in that last paragraph but there is a positive in there or I should say a potential positive. For one calendar quarter give or take a few days, it has a total return of 2.15% which would annualize out to 8.6%. If it can generate that sort of total return which is yet to be proven, and if, I say if, it delivers that sort of number with less volatility than the broad market then its attractiveness improves. Right here, right now I don't know if any of that will be true, it is too soon.

I am manually reinvesting the dividends, I started doing that before reading the article last week by Rida. I haven't drawn any conclusions about the fund yet. Selling puts is risky, depending on how it is done, it can be very risky. The WisdomTree PutWrite Strategy Fund (PUTW) has a much different implementation of the strategy and the numbers aren't great. The CAGR with dividends reinvested is 5.50%, 1.97% without and although its standard deviation is quite a bit lower that the S&P 500, during the Pandemic Crash of 2020 it pretty much dropped the same as the S&P 500. In 2022 it dropped 13% versus about 19% for the S&P 500. You can decide for yourself whether you think down 13% for an alt is good or not.

I believe the daily aspect of QQQY's strategy will make it less vulnerable to tracking the equity market down in a bear market than longer term puts used by PUTW. The way circuit breakers work has made a 1987 one day 20% crash almost impossible (it would play out differently) but a repeat of the Flash Crash of 2011 or 2016 would probably smack the hell out of QQQY.

This post mostly was just puking out thought process. The idea is intriguing, I do have some understanding of the strategy and it will either prove out as something that offers value or does not and today I can't say what the outcome will be. 

As for the title of this post, there was a graphic that referred to all of these funds with insanely high dividends as exchange traded income which I thought was a clever play on words. 

MENYX is in my ownership universe but not widely held.

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