Kris Abdelmessih took down covered call ETFs in a short but comprehensive blog post. It's an old post from last February so things have evolved in the space since then but his post is more about mechanics, specifically hidden costs beyond the expense ratio. The important takeaway is that liquidity providers know when funds need to come to market to sell calls. He used the Global X NASDAQ Covered Call ETF (QYLD) for this example.
Market makers can have a very good idea of how many calls QYLD needs to sell when they are rolling over their position and can trade such that volatility compresses, potentially pushing the price of the calls to be sold. That is of course bad for the seller, the fund, but is good for whoever is buying the options that the funds are selling. Kris asserts that there are no natural buyers for these calls, that it is the market makers who are buying. Whatever they might be doing to compress volatility, he says, is not illegal because they have no fiduciary obligation to the fund. By his estimation, this works out to an extra 100 basis points of expense beyond the expense ratio, like an opportunity cost.
He clearly understands this better than I do but there is an element of counter factuality in terms of what price a much smaller seller might get and I think it could be argued that a huge seller would compress volatility without any underhanded effort by any sort of liquidity provider.
I'm not saying he is wrong because I don't know, just that it is possible that the reality is less nefarious. If no one is doing anything underhanded and volatility compresses all the same, then it still is a hidden cost making the larger funds in the covered call space more expensive than they appear which is Kris' point. He cited other issues too but this was the most interesting to me.
There is a bigger point to explore. Anything but plain vanilla beta is going to be expensive. Advisors and investors need to figure out whether the extra expense is worth whatever they are getting out of more complex strategies/funds. The right answer is of course up to the individual. It is valid to buy the cheapest broad equity index ETF and just hold on no matter what. That will be emotionally difficult at times but other than managing sequence of return risk, it's valid. That sort of exposure will cost 4 basis points or less, there might still be a zero basis point index ETF but still, very cheap.
Where I talk about portfolios that are simplicity hedged with a little complexity, while the simplicity is usually cheap, hopefully the complexity, although probably expensive in nominal terms, is also cheap versus the benefit delivered to the portfolio.
The other day we looked at whether creating a 75/50 portfolio, 75% of the equity market's upside but only half the downside, might be more attainable thanks to how sophisticated strategies have made their way into mutual funds and some ETFs. Below is another one that could work for 75/50 with just two funds. It is 55% Vanguard S&P 500 ETF (VOO). VOO is simple market cap weighting (MCW) and at 3 basis points it is very cheap. The other 45% is in the AQR Macro Opportunities Fund (QGMIX). The fund is not simple and it is not nominally cheap. AQR provides some high level allocation information but the holdings report is a couple of hundred pages. QGMIX' expense ratio is 1.71%.
Unlike the funds we looked at the other day, this back test goes back pretty far. Portfolio 2 actually has captured 74% of the upside of 100% allocated to VOO and has never had a down calendar year. The max drawdown for Portfolio 2 occurred during the 2020 Pandemic Crash and you can see it fell about half as much during that event and as mentioned, it was up in 2022.
Portfolio 2 is not going to keep up with the S&P 500, at least it should not be expected to keep up. An 8+ percent CAGR with low volatility are attributes that will appeal to some, that is safe to say. Some portion of the people for whom that would be appealing will be turned off by the 1.71% percent expense ratio and some other portion will think it is worth it. I don't think there is a wrong answer.
Yes ETFs are cheaper than mutual funds typically but there are a lot of mutual funds for which there is no ETF substitute including QGMIX. Meb Faber (I think it is Meb) every once in a while will Tweet the amount of AUM in S&P 500 mutual funds that charge 1%. That is obviously an antiquated fee structure but people probably don't know what they are paying. There really is no reason to pay 1% for an S&P 500 fund when Vanguard S&P 500 Investor Fund (VFINX) charges the same 3 basis points as VOO.
If there is not an ETF that does what QGMIX does and someone is interested in the attributes, then they need to figure out for themselves how they feel about 1.71%.
Back in the real world, there are not too many scenarios where I would put 45% into one liquid alternative mutual fund. I use very small slices into several diversifiers that might be nominally expensive but I put nowhere near 45% of a portfolio into them. Having almost half the portfolio in funds that cost 1.5-2% is beyond what I am willing to do, but a small slice is a different story. I perceive value from that sort of allocation.
One scenario where something like Portfolio 2 might make more sense is a situation where a person has a some smaller account away from their primary retirement/investment account. Someone with several hundred thousand in a rollover IRA and some random account with $10,000, maybe something like Portfolio 2 makes sense but again, 100% in MCW would be valid.
Closing out with one more point about the Abdelmessih blog post is that part of what these conversations we have are about the net effect that the investor gets from the fund, covered call or otherwise. The study we did with VOO/QGMIX is net of everything. Any fund performance and volatility stats and anything else you see regarding a fund is net of fees, the ones that the funds charge as well as market inefficiencies that Kris was referring to.
I can't tell you what is right for you but getting a CAGR that meets your needs with a volatility profile you can live with does has some value. We each need to decide for ourselves what is a fair price.
The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.
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