Bloomberg had a fun article looking at whether the boom in hedge fund trades and ETFs that short volatility one way or another might cause some sort of negative stock market event. There have been volatility events before. The 1987 crash was partly attributed to selling portfolio insurance and there was the so called Volmageddon of 2018. The former was about selling index futures and the latter was about shorting the VIX.
Events don't repeat but the can rhyme. 2018 was not 1987 and if there is another event where volatility ends up being a major determent then it will be different than the other two but with some overlap. The behavioral overlap might be complacency. The strategic overlap might be a sophisticated tactic of selling a derivative of the market.
One interesting number about "derivative income" ETFs from the article was that in 2019, before the very popular JEPI ETF listed, they has $7 billion in AUM and a the end of 2023 the space had grown to $75 billion. The growth begs the question as to whether all that additional options selling is compressing volatility. A squeeze like that could compress volatility which could contribute to a sort of complacency that isn't bullish for markets.
The article seemed to go back and forth about the role these ETFs might play here and what the fallout might be to fund holders. The $75 billion number is not something I would worry about. Using terminology I've used a few other times over the years, if anything, "derivative income" funds are a mania, not a bubble. Manias can end badly for the space in question but bubbles are all encompassing like the internet bubble and the real estate bubble.
The risk of selling covered calls is nothing like shorting the VIX and don't have anywhere near the leverage that index futures do. Covered call funds are marketed as lower volatility but with market upside and income. The market upside doesn't seem to work out so well with funds that sell monthly calls which is most of them. In 2022, the bigger ones did go down less than the S&P 500 which was down 18%. That year JEPI was down 3.5%, PBP was down 11.8% and XYLD was down 12%. In 2023, they were up less than half what the S&P 500 gained.
2022 was more of a slower bear market and the promise of going down less worked out. If there is a volatility-caused crash, crashes are much faster and snap back much faster, then covered call funds may not soften the blow. The underlying basket of stocks will go down the same as plain vanilla market cap weighted but then because of how the monthly calls are sold, they may not capture the snap back.
The above is the Pandemic Crash of 2020. The covered call funds may have gone down a little less, but not much less and they did not capture the snap back. You can see where calls were sold at the start of April, PBP and XYLD traded sideways.
The crash at the end of 2018, above, was the same story.
The third chart is the same three ETF with the VIX added to capture the VIX spike that came to be known as Volmageddon that took out a couple of short-VIX ETNs. It is tough to see but the covered call funds didn't help much in the decline, they didn't make the decline worse though. None of these events were worse for the covered call funds. The snap backs were worse in two of the three instances. In the Volmageddon, the snap back wasn't immediate, stocks took another leg down and so it took a bit longer for the covered call funds to start to trail off again from VOO.
Bear markets and crashes come along every so often. That will not change going forward. I don't believe selling calls poses additional risk beyond whatever downside risk goes with market cap weighting. If the S&P goes down 30%, sure covered call funds could do a little worse, or better, but they are not going go down 50 or 60% in a down 30% world. If the S&P cuts in half again, these will too but again, that would be inline with market cap weighting. I also would not expect them to be down only 10% in a down 50% world either. Great if it happens, JEPI did outperform by a ton in 2022, but I would not expect it.
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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