Effective Derisking?

ProShares emailed out a short paper in support of the ProShares S&P 500 High Income ETF (ISPY). ISPY is a covered call fund and it's point of differentiation is that instead of selling monthly calls it sells daily calls. The idea is that by selling dailies, fund holders can capture more of the S&P 500's upside versus selling monthlies. The idea makes intuitive sense and so far it seems mostly correct. 

Quick disclaimer that I am test driving ISPY in one of my accounts for possible use for clients. 

From the start of 2024 it was closer to the S&P 500 than XYLD which sells monthly calls but ISPY felt more of the market's downside move in early April than XYLD. I think ISPY had more downside because of the smaller premiums taken in from daily selling than monthly selling. To capture the ISPY dividends for a more accurate total return number, we'd need to add in about 2.5% to the 3.1%. How does 5.6% versus 7.0% (plus 35-40 basis points or so for the S&P 500's dividend) sit with you? Is that enough upcapture? For XYLD, we'd add back 3.2% for a total of 4.8% YTD return. Remembering that nothing can be infallible, ISPY is mostly doing what they said it would do so that is a positive but again, is the upcapture sufficient? That's what I'm trying to figure out and that will take time so this is sort of just a progress report. 

As a coincidence, Ben Carlson and Michael Batnick had Eric Metz from SpiderRock Advisors on one of their podcasts talking about options. SpiderRock is a pretty big firm specializing in providing outsourced option strategies to advisory firms.

Sidebar, I don't know where the name SpiderRock comes from but there is a Spider Rock formation in the middle of Canyon de Chelly.

Anywho, the podcast didn't have a lot of meat on the bone but there was one thought provoking point that I wanted to explore. Metz talked a little about using options to help derisk a portfolio as someone approaches or moves into retirement or the decumulation phase. 

The context was more about using options to manage the risk of large positions of company stock than using ETFs with some sort of options overlay in pursuit of less volatility. If you have a portfolio with 20-40 holdings without a disproportionate weighting in one stock (from your employer or anywhere else), I'm not sure using options to derisk each position makes sense. 

Funds that employ options strategies offer the promise of lower volatility, a form of derisking but as noted above they are not infallible, nothing is. As I mentioned, ISPY was down on lockstep with the S&P 500 for the first three weeks of April.

For all the different types of option strategies now accessible through funds, the attributes are different enough that they'll help smooth out the ride in different ways during different types of market events. I think solving the idea of how to derisk comes down to a couple of things, finding the more reliable derisking effect as well as maintaining the proper asset allocation for the investor in question. 

An investor who has enough money such that their plan will probably work needs something close to a normal exposure to equities. Someone who is very far ahead of the game can usually get away with having more allocated to lower volatility strategies whether that is options funds or something else. An investor who is very far behind might be better off with no equity exposure for fear that sequence of return risk would blow them up. There are countless examples, these were just some very basic ones. 

I believe the better way to derisk is by blending plain vanilla equity exposure with alts that combine to bring down portfolio volatility instead of owning funds that should have less volatility. As we've looked at many times, this approach does reduce volatility but with the opportunity for more upcapture. 

Ten years is a good sample size and to be clear, all of these lagged 100% exposure to the S&P 500 which in the same period had a CAGR of 12.73 but a standard deviation of 15.05%. You can see for yourself how that compares and decide for yourself what appeals to you. The examples I used for this point are over simplified versus real world portfolio construction. BTAL in Portfolio 1 is a client and personal holding. 

My hunch is that ISPY can have better upcapture than XYLD (four months is too short to conclude anything) but I would need to see it hug the market cap weighted index closer than it has so far to want to anchor around it. 

To the extent an options strategy fund could be thought of as a factor, I continue to believe there is a way to blend in a covered call fund with another factor or two to find something that is a proxy for market cap weighted exposure but that does a little better. I haven't found that yet but I think it is worth pursuing.

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.