The Secret to Success with Options-Based Funds

Long-term investors may have the best results with buy-write funds

Feb 25, 2015 at 9:25 AM
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The paper we cited yesterday claimed that option-based exchange-traded funds (ETFs) outperformed the S&P 500 Index (SPX) over the long haul, and did so with reduced portfolio volatility. And I don't dispute that conclusion. But it's important to remember that results may vary.

In other words, over shorter time frames, you may end up quite disappointed. I intuitively thought that the last couple of years were likely good times for "buy-write"-type funds. We've rallied, but not explosively so. And implied volatility has consistently overpriced realized volatility. It seems like a good backdrop.

But maybe not. Here's a look at Horizons S&P 500 Covered Call ETF (HSPX) versus SPX over the past 1.75 years.

HSPX vs. SPX over the past 1.75 years

I have to admit, I've never heard of HSPX. Here's the description:

"HSPX invests its total assets in all the securities of the S&P 500 ® in substantially similar weights, and sells or "writes" covered call options on up to 100% of each of the option-eligible securities in the portfolio in an attempt to generate additional monthly income from the call option premiums collected."

So in other words, it buy-writes every name it can in SPX -- sounds perfect for this study. Yet, look at the graph; it barely captured one-third of the SPX gains.

Maybe selling calls on individual names doesn't work so well on a net basis. Even though index options tend to overprice ultimate realized volatility, the same isn't true for all stocks. There are all sorts of big moves on earnings, mergers, or whatever. And the losers could dwarf the winners in size. So how about we look at a fund that just sells index calls -- like the PowerShares S&P 500 BuyWrite Portfolio (PBP).

"The PowerShares S&P 500 BuyWrite Portfolio (Fund) is based on the CBOE S&P 500 BuyWrite Index ™ (Index). The Fund generally will invest at least 90% of its total assets in securities that comprise the Index and will write (sell) call options thereon. The Index is a total return benchmark index that is designed to track the performance of a hypothetical "buy-write" strategy on the S&P 500 ® Index. The Index measures the total rate of return of an S&P 500 covered call strategy. This strategy consists of holding a long position indexed to the S&P 500 Index and selling a succession of covered call options, each with an exercise price at or above the prevailing price level of the S&P 500 Index. Dividends paid on the component stocks underlying the S&P 500 and the dollar value of option premiums received from written options are reinvested. The Fund and the Index are rebalanced and reconstituted quarterly."

Sounds good. But here's the chart of PBP versus SPX over the same time frame as above.

PBP vs. SPX over the past 1.75 years

Oops. That 2.8% return stands up pretty poorly versus the 36% SPX gain.

How about Barclays ETN+ S&P VEQTOR ETN (VQT)? I've mentioned this pup before. It's a little different in that it's dynamic. It sits with a pure SPX position until volatility makes a predetermined move, at which point it purchases CBOE Volatility Index (VIX) hedges. And if volatility keeps going, it goes to all cash. It wouldn't qualify for the study in that it's not an options-based ETF per se (yes, I know VIX itself is options-based), but it should accomplish the same smoothing of market moves. Anyway, here it is stacked up against the SPX.

VQT vs. SPX over the past 1.75 years

Well, it is better than the others -- VQT picked up about half the gains of SPX. And it should do very well (on a relative basis) in a weak market, as it would get to all cash at some juncture.

Now, it's not terribly fair to pick out one two-year slice of two ETFs in a study that looks at 80 funds and goes back to 1988. But it is key to note that lots of investors have bought into these types of funds or tried to replicate the ideas on their own, and they've come away disappointed for no other reason than they had unfortunate timing. It's a solid portfolio idea; it just requires a very long-term time horizon to see the full benefits they lay out.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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