How To Harness Volatility

If you read this site regularly (thank you), you may have noticed that I bag on quite a few of the ETFs from Simplify, there are quite a few that seem to me to not work very well. It is only fair then to point out one that appears to be working. I've mentioned the Simplify Hedged Equity ETF (HEQT) once or twice early on when it listed a couple of years ago. 

The basic strategy is to own the S&P 500 via the iShares S&P 500 (IVV) which is in my ownership universe. It pairs IVV with option combos, specifically it sells covered calls above the market and buys put spreads (debit) below the market. It staggers the option combos out over three months. Based on the fund's position page, the February calls are struck at 4725 so it is pegged on those options, the Marches are struck at 4950 so still a little room there and the Aprils are struck at 5020. A drawback is that the fund has paid out capital gains for 2022 and 2023, you can look on the website for more details on that. Not sure if the distributions are taxed 60/40 but they should be able to tell you. 

Here's how it looks on a chart.

Looking at the two+ years in aggregate it is pretty close to the 75/50 result we talk about frequently. Breaking it down though, in 2022 it was down 8.25% versus 18.19 for VOO and last year it was up half of what VOO gained. I would not expect it to maintain a 75/50 trajectory in perpetuity but it could be close. In up years that are less dramatic than 2023 there's a good chance it could track closer to the S&P 500 because there's less risk of the index going way above the call strike prices which would be favorable for HEQT. 

The CAGR information on the chart doesn't help much for only being two years but since inception, VOO  has compounded at over 13% and longer than that, the Vanguard S&P 500 has compounded at just over 11% for 39 years. While I would not expect HEQT to compound at 75% of the S&P 500, would 60-65% be meaningful? As a trade off for a meaningfully smoother ride, yeah it might be. For someone who is a little ahead of the game, not needing full equity exposure, HEQT seems like it might be able to stay ahead of inflation, like plain vanilla equities, which is a decent objective for someone who is ahead of the game some. No growth is probably a bad idea, but less volatile growth? Maybe, yeah and maybe HEQT can fill that role. I did not model it into a portfolio because of how short the track record is.

Pivoting, I stumbled into the CBOE Validus S&P 500 Dynamic PutWrite Index ETF (PUTD). It just started trading last summer and as the name indicates it sells S&P 500 Index puts and hold the cash in T-bills. We talked about this the other day but this fund is essentially a way to add volatility as an asset class. Volatility can be bought like with a long VIX product or tail risk fun and volatility can be sold like with putwrite funds and covered call funds. Any kind of strategy that harnesses volatility has its risks that can be complicated and that need to be understood.

Generically, the big risk to selling puts is that the market goes down a lot, below the strike price of the puts being sold which creates a loss. The chart shows two longer standing putwrite funds with very different strategies.

Selling puts is sometimes described as picking up nickels in front of a steamroller and you can see why from the Pandemic Crash of 2020. It was fast but at it's worst, the S&P 500 was down more than 30%, the Wisdomtree fund (PUTW) was down more than 20% and Princeton Premium (PPFIX) which is a client and personal holding was down a little over 10%. The difference can be accounted for by which puts are sold. PUTW sells very close to the money and so it takes on a lot more equity beta. Using the steamroller analogy, PPFIX is picking up pennies a mile in front of the steamroller, it sells puts that are very far out of the money. It brings in less premium but has far less volatility and really looks nothing like the equity market. 

If you wanted more of an equity proxy, then PUTW would be the one to study and if you were looking for more of an absolute return result then PPFIX is the one to study and it is why I use it. 

PUTD, the new fund will be closer to PUTW in strategy and should take on equity beta, put selling is a bullish strategy so should equity beta should be expected unless told otherwise like with PPFIX. The put strategy that PUTD employs is less rigid than PUTW. The prospectus says it is an indexed fund but then also refers to a dynamic selection process. It's a secret sauce situation but please comment if you can decipher more than I've been able to do.The PUTD literature seems confident that it can stay pretty close to the equity market but with smaller drawdowns. 

It is too early to conclude anything about the fund but so far it has had a smoother ride than the S&P 500 and captured more upside than PUTW. The first few months for a strategy like this really is too soon to conclude anything but it's start is better than the alternative of being a real stinker out of the blocks which happens sometimes. 

A final point is that I did not take the time in this post to really define the option terminology. These funds should probably be avoided until you learn about the options concepts mentioned. It is learnable, it's not that opaque but where these are not plain vanilla, they take extra work.

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.