Income from innovation, or overwriting?
Portfolio Design: Product Review
Today we’re bringing the band together, and debuting a new tune.
Rather than keeping my other blog Portfolio Design separate from The Till, I’d like to expand the content for both groups. The mission remains the same - understanding the lessons taught by options, and discovering the best ways to trade them.
The regular edition of the Till will continue to be an editorial about these markets, free for all. Stories from the pits, market structure geekery, options musing - the ruminations of a recovering market maker.
Portfolio Design editions are dedicated to practicum of trading options strategies. An advisor at work - but not investment advice. This premium content will center around three themes. Backtest Notebooks is for the analysis of trading strategies using historical data - like how multiple tickers work in concert. Fifty Ways to Trade an Option is about specific trade structures, and their various use cases - like making volatility based adjustments to a hedged equity strategy.
That leaves our newest theme - Product Reviews.
Relatively recent rule changes about ETFs (2019) as well as booming liquidity in options has created a vast spectrum of exchange listed vehicles that track an expanding list of trading strategies. New flavors come on to the market nearly every day. Not all active ETFs are options strategies, but the category has caught fire.
If you’ve been following along here, you know I’m skeptical about packaging options strategies in a neat little wrapper. I’ll be the first to praise their accessibility though - it’s a lot easier to click buy once than deal with opening, rolling, and closing a position every expiration cycle.
It also publicizes the potential of options strategies with a far bigger megaphone than me and my soapbox. There’s a LOT you can do with this toolkit. There’s also a lot of ways you can get screwed.
My hope for these Product Reviews is to highlight the good things going on in financial innovation. And shed some light on things that might not be structured to deliver the objective on the wrapper. Regardless, none of this is a recommendation - do your own research or contact an advisor.
In addition to an overview of the underlying strategy, I’ll provide a three part review. Structure captures whether the product is respecting options as a derivatives, and applying sound investment strategies. Risk/Reward is a measure of how well the product uses derivatives to improve outcomes. Implementation Shortfall is a rating of how closely the product is able to replicate the “pure” strategy decomposed with listed options.
So tune in below, for our first product review, where we take a look at the product FEPI - the FANG & Innovation Equity Premium Income ETF.
The first edition over here will be free. I hope you like it.
Overview:
It’s tough to find a name with durability, and the “FANG” moniker is quickly going the way of pandemic masking. Not only are these tickers technically MANG, the scope of “interesting mega cap tech” has broadened. Luckily the “Innovation” component can do the heavy lifting here.
The objective of this fund is to “Own Big Tech, Write Covered Calls” and get “Enhanced Income Potential”. Tech has been particularly dominant in the medium term past, and also tends to have elevated implied volatility. That sounds like a good environment for a long delta, short premium strategy.
The fund’s benchmark index is the Solactive FANG Innovation Index, which has eight core holdings (AAPL, AMZN, META, GOOGL, MSFT, NFLX, NVDA, TSLA) and seven additional holdings of the most actively traded names from technology sectors. Tickers are equally weighted, rebalanced monthly, and reconstituted quarterly.
Overall returns have been slightly positive over the past year but it’s important to compare that to a) the NDX is are up 22% YoY and b) the twelve month distribution rate of FEPI is 29%. Flat in a bull market, and the ticker is going down while you’re getting big checks back every month.
Structure:
The covered call is a benchmark options strategy, but there is more than meets the eye with this overlay. Options premia are definitely not “income” so any conflation of those two is disingenuous at best.
“FEPI aims for enhanced income by selling out of the money call options, harnessing big tech’s volatility while capping some of the potential stock gains.” There’s some clever wordplay here, as out of the money calls of course have lower premium rates, but the fund seeks to capture some of the capital appreciation of the (potential) stock gains.
Targeting big tech companies makes sense from a liquidity and performance perspective, but volatility fits in a different category. Volatility describes the risk of asset price movements, not direction. Treating high volatility as a feature ignores whether it’s appropriately priced.
With regards to the equal weighting, the prospectus cites this: “While market capitalization weighted indices can be dominated by a few of the largest stocks in the index, an equal weighting approach allows for a more balanced exposure and reduces concentration risk.”
Since the index was constructed in June 2021, it has notched a 51% gain compared to a 45% gain for the Nasdaq 100, which is market cap weighted and broader. That’s a small but real outperformance, and with fewer components this underlying basket allows the product to take advantage of a feature of single asset vs. index volatility.
Individual stocks have higher volatility than when combined into an index, the relative levels of this being dispersion. If the basket of underlyings tracks the index well (even beats), and you can sell higher premiums, that is a positive feature.
The conversion of assets into distributions is an important structure to pay attention to. The fund consistently flags 100% of distributions as “Return of Capital.” (Check out their latest 19a-1 form for more information.) This means that while the investor won’t pay tax on it presently, it does reduce the cost basis. If the basis goes to 0, future distributions are taxed as capital gains.
Everyone’s tax situation is different, but a reduced basis could mean you’re on the hook for capital gains upon selling the product, or at least reduced capital losses. It’s also representative of what this strategy is actually achieving under the hood. If you want to simulate annuity like distributions, there are other clever ways to do that with options. You might even get some net positive tax features using index products or simply taking short term losses when calls go in the money.
There are pros and cons to both the concentrated structure, as well as the tax engineering. Pay attention to your individual situation and understand these vectors of exposure.
Implementation Shortfall:
Covered calls are simple, but fairly tedious. Some of that comes just from regularly having to roll a strategy, but a savvy overwriter will also be paying attention to pricing indicators (e.g. VRP, IV, or Skew levels) to determine if the sale makes sense. The ongoing sell mandate in this strategy will be a drag on returns, as implied volatility is not always overpriced.
Another advantage of being in a fund is that larger AUMs can trade more diversified structures across products and strikes. To simply buy a round lot of all the names is $430k, and to start approximating equal weighting its $1.4M.
Further, with $460M of capital, the fund can start trading across different strikes to smooth out the returns. While they’re almost always in the same expiration (time tranching could be a benefit too), there are as many as 4 different strikes per ticker in the latest filing.
None of their sizing is close to spooking liquidity. An 11,700 lot is the biggest in INTC, and the serial expirations have many multiples of that in open interest.
While the prospectus indicates that they have the ability to use FLEX options, current holdings don’t suggest that. That’s something to pay attention to, as the market width and slippage on those trades are likely to be more significant.
Overall, the drag of a systematic strategy has a significant impact on returns, but the actual implementation of this strategy has several beneficial features.
Risk / Reward:
The fund’s short history comes at a very convenient time. Covered calls are long delta trades. The best possible scenario for a covered call is when the stock goes right up to the short strike. If the underlying basket of stocks is rising, we’re squarely in rewards territory.
And yet total returns are less than t-bills. To be fair you won’t be taxed on those distributions, but you’re down purchasing power. Taxes aren’t bad if you are making real money.
In a down market scenario, this strategy is completely exposed. Covered call premiums at the thirty day level range from 1-3% in these names. That barely cushions a teddy bear market, and that high volatility you came to sell comes in to collect.
It’s extremely important to understand the covered call trade off. You accept the left tail of volatility, and give away the right tail. If this is really the basket of innovative future defining companies, you’d expect asset prices to push ever upwards, do you really want to give that away for a few bucks, and take all of the bear market risk?
If the best case is meh, watch out below.
I’d love to hear from you.