Deconstructing Options Funds

Finomial wrote about replicating multi-strategy hedge fund ETFs with 40-50% in plain vanilla equities and the rest in cash. The two multi-strategy hedge fund ETFs they studied were QAI which has been around for a long time and HFND which has been around for a couple of years or so. Both have very low volatility and very low returns. Read the post if you want to learn more about what Finomial found but the bigger idea of replication or as I've preferred to call it, proxies, is something we've looked at countless times with countless funds and strategies. I think this sort of study helps to better understand how different exposures blend together. 

Thinking about what I believe QAI and HFND are trying to do, I thought about the Simplify Hedged Equity ETF (HEQT). And if we're going to look at that one, we might as well look at the Simplify Equity PLUS Downside Convexity ETF (SPD). I've bagged on the Simplify funds pretty hard. Most of the ones we've looked at, don't appear to "work" very well but a couple of them absolutely do, or at least they have so far. HEQT appears to work and SPD does not seem to me like it works very well. It's interesting because the strategies are fairly similar. 

2022 says it all to me, SPD was down a lot more than the S&P 500 and HEQT was down much less.

SPD owns the S&P 500 with a put option overlay as follows. The positions as of July 9th.

I tried to color code the put spreads and then in addition to the three put spreads, there is a simple long put position struck at 4880. Looking at the spread highlighted in yellow, the position will stop protecting if the S&P 500 goes below 5000. Without being able to look back, I wonder if 2022's poor result was because the market kept falling past the short leg of the spreads used. You can see the green colored spread expires at the end of next week. That spread is so far out of the money that it's more like tail risk than downside protection. The index wouldn't have to fall all the way down to 4230 for the long leg of that spread to start going up in value but I don't believe that option would move in the face of a more mundane 5% pullback and not that much if the index fell 10% in that time, if you know differently please leave a comment. The puts expiring on July 15 have a better chance of moving if the market dropped 5% for the rest of the week.

HEQT buys put spreads and sells call options.

I paired off the spreads based on expiration dates. The first thing I notice is that HEQT uses much wider spreads. This makes the spreads more expensive in nominal terms versus SPD but maybe that expense is offset by selling the calls. The calls that expire next week have capped about 1/3 of IVV's gains since the S&P hit 5290 back in mid-May. These options settle for cash so they can let the calls expire and take the hit that way or try to roll them forward to what I am guessing would be October but in eyeballing the option chain, rolling forward looks like it would be done at a costly debit. If the S&P 500 keeps going parabolic then the same thing could happen with the August calls.

If my look through is correct, I'll be curious to see what happens next week with HEQT's price.

As I said, I think HEQT generally has worked but SPD has not. Any sort of fund that hedges with options will have to endure a cost for that hedge whether that is the cost of the puts or giving away appreciation above the strike prices of the covered calls. So how much upside can you get and what sort of protection do you get? In 2023, HEQT had 61% upside capture and in 2022 it had 44% downside capture. Framing that it in terms of 75/50, 75% of the upside with only 50% of the downside, it got close in two individual extreme years. Over the entire period HEQT was 87/50. So that is interesting. 

Tying it together, you can see the portfolio comparison below that is also interesting.

HEQT has a 0.95% correlation to VBAIX which in this case is a positive. HEQT isn't a diversifier, the exploration here is whether it could be a proxy for 60/40 or somehow part of the solution in creating a better proxy for 60/40. The time period is very short but for now the answer isn't no and maybe it evolves into being yes. Just to qualify something, I'm never putting 40% into managed futures, it's just a blog post. 

A final point, I used a lot of options jargon without defining it. I'm glad to answer questions in the comments but I didn't want to subject readers to a 4000 word technical paper. 

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.